The number of units sold can be multiplied by the average price per unit to establish COGS and the ending inventory — the value of goods still available for sale and held by a company at the end of an accounting period. The term cost flow assumptions refers to the manner in which costs are removed from a company’s inventory and are reported as the COGS. In the U.S., the common cost flow assumptions are First-in, First-out (FIFO), Last-in, First-out (LIFO), and average. Additionally, there are ways to estimate ending inventory, such as the retail inventory method, and it is possible to assign costs to inventory using the actual cost of each item (specific identification method). When making an inventory cost flow assumption, what factors do managers need to consider?
Which of these is most important for your financial advisor to have?
The company’s profit relating to consigned goods is normally limited to a percentage of the sales proceeds at the time of sale. If the bookstore sold the textbook for $110, its gross profit using periodic LIFO will an assumption about cost flow is used be $20 ($110 – $90). If the costs of textbooks continue to increase, periodic LIFO will always result in the least amount of profit. The reason is that the last costs will always be higher than the first costs.
Comprehensive Example—Weighted Average (Perpetual)
The second disadvantage of this method is its susceptibility to earnings-management techniques. If a manager wanted to manipulate the current period net income, he or she could do this very easily using this method by simply choosing which items to sell and which to retain in inventory. Lower cost items could be shipped to customers, which would result in lower cost of goods sold, higher profits, and higher inventory values on the statement of financial position.
Effect of Inventory Errors on the Financial Statements
- There are two components necessary to determine the inventory value disclosed on a corporation’s balance sheet.
- Under the FIFO cost flow assumption, the first (oldest) costs are the first costs to leave inventory and be reported as the cost of goods sold on the income statement.
- When costs are assigned to these items and these individual costs are added, a total inventory amount is calculated.
- Simply by raising or lowering tax rates, the government can take money out of the economy (and slow public spending) or leave money in the economy (and increase public spending).
If you refer back to the simple example on this page, you’ll see that on a LIFO basis, the firm’s gross margin is $15. This is because the 15 December 2019 purchase is matched against the $100 sale. Many accountants argue, however, that LIFO provides a more realistic income figure. The reason is that it eliminates a substantial portion of inventory profit.
Rising Prices and FIFO
Depending on the costs and benefits, other firms might want to maintain similar records. Therefore, in our illustration, the beginning inventory for the next period is carried forward in two layers of 500 units at $4.00 and 100 units at $4.10. When the LIFO method is used, it is important to maintain separate layers of costs of ending inventory.
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Understanding this relationship is the key to estimating inventory using either the gross profit or retail inventory methods, discussed below. First-in, first-out (FIFO) assumes that the first goods purchased are the first ones sold. A FIFO cost flow assumption makes sense when inventory consists of perishable items such as groceries and other time-sensitive goods.
This article compares the effect of different cost flow assumptions—FIFO, average cost, and LIFO—on ending inventory, cost of goods sold, and gross margin for the Cerf Company. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that using an average of all costs is the most logical solution. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units). In Chapter 5 the journal entries to record the sale of merchandise were introduced.
However, it can be a more complicated system to implement especially if costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at such practical decisions based on an evaluation of advantages and disadvantages and not on theoretical merit. For this retail store, the following financial information is reported if FIFO is applied.
