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Inventory and Depreciation

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Inventory and Depreciation Inventory and Depreciation Learning Unit C-1 HOW TO ASSIGN COSTS TO ENDING INVENTORY ITEMS The method one uses to assign costs to ending inventory will have a direct effect on the company’s cost of goods sold and profit. Look at the accompanying diagram and note that in each column that ending inventory has a different value assigned to it. Note also how this affects gross profit in each of the four columns. A B CD Net sales $50,000 $50,000 $50,000 $50,000 Beginning Inventory $ 4,000 $ 4,000 $ 4,000 $ 4,000 Net Purchases 20,000 20,000 20,000 20,000 Cost of Goods Available 24,000 24,000 24,000 24,000 for Sale Ending Inventory 5,000 6,000 7,000 8,000 Cost of Goods Sold 19,000 18,000 17,000 16,000 Gross Profit $31,000 $32,000 $33,000 $34,000 If all inventory brought into a store had the same cost, it would be simple to calculate ending inventory, and we would not have to include this appendix in the book. Unfortunately, things are not that easy; often the very same products are pur- chased and brought into the store at different costs during the same accounting period. Over the years there have developed four generally accepted methods to assign a cost to ending inventory. They are: (1) specific invoice, (2) weighted-average, (3) first-in, first-out, and (4) last-in, first-out. Each is based on the flow of costs, not the flow of goods (the actual physical movement of goods sold in a store). SPECIFIC INVOICE METHOD Jones Hardware sells rakes. At the end of the period 12 rakes remain unsold. Notice in the accompanying table on page C-2 that on January 1, at the start of the accounting period, 10 rakes were on hand, but during the period additional pur- chases of rakes were made. The price given is the purchase price paid by the store—it is not the same as the selling price, which is what the store charges its customers for the rakes. The selling price is not involved here. At the bottom of the chart you can see that 44 rakes cost Jones Hardware $543. C-1 C-2 INVENTORY AND DEPRECIATION In the specific invoice method, one assigns the cost of ending inventory by iden- tifying each item in that inventory by a specific purchase price and invoice number. Items can be identified by serial number, physical description, or location. Using this method, Jones Hardware knew that six of the rakes not sold were from the March 15 invoice and the other six were from the August 18 purchase. Thus $150 was assigned as the actual cost of ending inventory. If the total cost of goods available for sale is $543 and we subtract the actual cost of ending inventory ($150), this method pro- vides a figure of $393 for cost of goods sold. Specific Invoice Method Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $100 March 15 Purchased 9 @ 12 = 108 6 @ $12 $ 72 August 18 Purchased 20 @ 13 = 260 6 @ 13 78 November 15 Purchased 5 @ 15 = 75 44 $543 12 $150 Cost of Goods Available for Sale $543 Less: Cost of Ending Inventory 150 = Cost of Goods Sold $393 Let’s look at pros and cons of this method: Specific Invoice Method Pros Cons 1. Simple to use if company has small 1. Difficult to use for goods amount of high-cost goods—for with large unit volume and example, autos, jewels, boats, small unit prices—for example, antiques, etc. nails at a hardware store, 2. Flow of goods and flow of cost are packages of tooth paste at a the same. drug store. 3. Costs are matched with the sales 2. Difficult to use for decision- they helped to produce. making purposes—ordinarily an impractical approach. WEIGHTED-AVERAGE METHOD The weighted-average method calculates an average unit cost by dividing the total cost of goods available for sale by the total units of goods available for sale. Since we don’t know exactly which items are left in ending inventory, we will calculate the aver- age of all the goods we have available in order to come up with a fair approximation of the cost of the ending inventory. INVENTORY AND DEPRECIATION C-3 Weighted-Average Method Goods Available for Sale Units Cost Total January 1 Beg. Inventory 10 @ $10 = $100 March 15 Purchased 9 @ 12 = 108 August 18 Purchased 20 @ 13 = 260 November 15 Purchased 5 @ 15 = 75 44 $543 $543 = $12.34 weighted-average cost per unit 44 Cost of Goods Available for Sale $543.00 12 rakes ϫ $12.34 = $148.08 Less: Cost of Ending Inventory 148.08 = Cost of Goods Sold $394.92 The pros and cons of this method: Weighted-Average Method Pros Cons 1. Weighted-average takes 1. Current prices have no more signifi- into account the number of cance than prices of goods bought units purchased at each amount, months earlier. not a simple average cost. 2. Compared to other methods, the Good for products sold in most recent costs are not matched large volume, such as grains with current sales. and fuels. 3. Cost of ending inventory is not as 2. Accountant assigns an equal up-to-date as it could be using unit cost to each unit of inventory; another method. thus, when the income statement is prepared, net income will not fluctuate as much as with other methods. FIRST-IN, FIRST-OUT METHOD (FIFO) In the FIFO method, one assumes that the oldest goods (rakes, in this case) are sold first. In other words, the first merchandise brought into the store tends to be sold first. Indeed, it is often the sale of these items that prompts the store to buy more of them—as they start to run out, the store purchases more. When costs are assigned in the FIFO method, the cost of the last items brought into the store is assigned to ending inventory and the inventory sold is assigned to cost of goods sold. For example, using our Jones Hardware situation, the ending inventory of 12 rakes on hand are assigned a cost from the last two purchases of rakes (purchases made on November 15 and some purchases made on August 8), $166. Using the FIFO method, it is always assumed that it is the most recently pur- chased merchandise that has not been sold. Look at how this works out in the accompanying table on page C-4. C-4 INVENTORY AND DEPRECIATION First-In, First-Out (FIFO) Method Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $100 March 15 Purchased 9 @ 12 = 108 August 18 Purchased 20 @ 13 = 260 7 @ $13 = 91 November 15 Purchased 5 @ 15 = 75 5 @ 15 = 75 44 $543 12 $166 Cost of Goods Available for Sale $543 Less: Cost of Ending Inventory 166 = Cost of Goods Sold $377 If you are having difficulty with this, think of the inventory as being taken from the bottom layer first, then the next one up, and the next one up, etc. The pros and cons of this method: First-In, First-Out (FIFO) Method Pros Cons 1. The cost flow tends to follow the 1. During inflation this method physical flow (most businesses try will produce higher income to sell the old goods first—for on the income statement— example, perishables such as fruit thus more taxes to be paid. or vegetables). (We will discuss this later in 2. The figure for ending inventory this appendix.) is made up of current costs 2. Recent costs are not matched with on the balance sheet (since recent sales, since we assume old inventory left over is assumed to goods are sold first. be from goods last brought into the store). LAST-IN, FIRST-OUT METHOD (LIFO) Under the LIFO method, it is assumed that the rakes most recently acquired by Jones are sold first. In other words, the last merchandise brought into the store is the first to be sold. As an example of this method, think of a barrel of nails. It is the most recently purchased nails, which are at the top of the barrel, that are sold first—the nails at the bottom of the barrel are sold last. Note in the accompanying table on page C-4 that the 12 rakes not sold were assigned costs based on the old inventory of January and March that totaled $124, giving Jones a cost of goods sold of $419. INVENTORY AND DEPRECIATION C-5 Last-In, First-Out (LIFO) Method Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $100 10 @ $10 = $100 March 15 Purchased 9 @ 12 = 108 2 @ 12 = $ 24 August 18 Purchased 20 @ 13 = 260 November 15 Purchased 5 @ 15 = 75 44 $543 12 $124 Cost of Goods Available for Sale $543 Less: Cost of Ending Inventory 124 = Cost of Goods Sold $419 These are the pros and cons of this method: Last-In, First-Out (LIFO) Method Pros Cons 1. Cost of goods sold is stated at or 1. Ending inventory is valued at near current costs, since costs of very old prices. latest goods acquired are used. 2. Doesn’t match physical flow of 2. Matches current costs with current goods (but can still be used to selling prices.
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