The cost of ending inventory and the cost of goods sold is determined using various methods of them, the commonly used methods are:
- First-in first-out (FIFO),
- Last in first-out (LIFO), and
- Weighted average.
All expenditures needed to acquire goods and to make them ready for sale are included as the inventorial cost. It appears from the diagram that; the
cost of goods available for sale = cost of beginning inventory + cost of goods purchased
cost of goods sold = cost of goods available for sale – ending inventory.
But in practice, goods are purchased several times at different prices for a particular period, and the same is the case with sales.
In such a situation, the determination of the cost of ending inventory becomes very difficult. These methods are described below with an example.
First, let’s look at the information given in the following table;
|Date||Explanations||Units||Unit Cost ($)||Total cost ($)|
|Jan. 1, 2019||Beginning inventory||200||20||4,000|
|Apr. 15, 2019||Purchases||400||22||8,800|
|Aug. 8, 2019||Purchases||600||24||14,400|
|Nov. 27, 2019||Purchases||800||26||20,800|
|*Ending Inventory on Dec-31-2019 was 900 units.||TOTAL:||2000||48.000|
Now see the definitions and see what the cost of ending inventory in each method is;
Under this method, to price the issues, it is assumed that the last receipts are issued first. The major objectives of the LIFO method are to change the cost of goods sold with the most recent cost incurred.
The FIFO method assumes that the earliest goods purchased are the first to be sold, FIFO often parallels the actual physical.flow of merchandise, it generally is a good business practice as to sell the oldest unit first.
Inventory method that assumes that the costs of the earliest goods purchased are the first to be recognized as cost of goods sold.
Inventory costing method uses the weighted average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale.
The average cost method will take the total cost of goods that will available for sale and divide it by the total sum of the product from the inventory and purchases.
What are the relationships of FIFO, LIFO, and Average Inventory System?
The following points show the relationship between LIFO, FIFO and average inventory system:-
- Inventory Cost Determination: Since they are different, but the objectives of this method are the same.
- Income Effect: The cost of this method can vary, but the effect of income in financial statements is the same.
- Revenue Matching: The cost of each method be varied, but this be matched with the revenue section.
- Inventory Level Determination: Each method indicates how many units should be produced and how much saved.
Among FIFO, LIFO, and Average Inventory System, the LIFO is the best measure because;
- The major objectives Of the LIFO method to change the cost of goods sold with the most recent cost incurred.
- Adjust the financial statements for inflation.
- To obtain a better matching of current revenues with current costs in times of inflation.
Difference between FIFO, LIFO, and Average Inventory System?
(First In First Out)
(Last In First Out)
|Average Inventory System|
|1. Meaning||Inventory costing method that assumes that the costs of the earliest goods purchased are the first to be recognized as the cost of goods sold.||Inventory costing method that assumes that the costs of the latest unit purchased are the first to be allocated to cost ooff goods sold.||The average inventory method assumes that using in the smoothes out cost fluctuation by the cost of goods sold.|
|2. Measurement of profit||FIFO is good when the price level is high.||LIFO is good when the price level is low or high.||When the price of inventory fluctuates.|
|3. The effect in Financial Statement||FIFO method effect in the balance sheet of financial statements.||LIFO is method affects the income statements of financial statements.||The effect of both income and balance sheet.|
|4. Matching with cost and revenue||It is not possible to match the cost and revenue in the FIFO method.||It is possible to match the cost and revenue in the LIFO method.||Cost and revenue matching is not possible.|
|5. Restrictions||There are no GAAP or IFRS restrictions for using FIFO, and both allow this accounting method to be used.||IFRS does not allow using LIFO accounting.||Only the large firm used the inventory method.|
|6. Unsold inventory||Unsold inventory is comprised of goods acquired most recently.||Unsold- inventory is comprised of the earliest acquired goods.||Both recent and earliest unsold inventory.|
|7. Effect of Inflation||If the cost is increasing, the items acquired first were cheaper. This decreases the cost of goods(COGS) under FIFO and increases profit. The income tax is larger. The value of unsold inventory is higher.||If costs are increasing, then recently acquired items are more expensive. This increases the cost of goods sold(COGS) under LIFO and decreases the net profit. The income tax is smaller. The value of unsold inventory is lower.||There is an effect in inflation|
|8. Effect of deflation||Converse to the inflation, scenario, accounting profits (and therefore tax) is lower using FIFO in a deflationary period; the value of unsold inventory is lower.||Using LIFO for a deflationary period results in both accounting profit and the value of unsold inventory is higher.||The average method is not fit.|
|9. Record Keeping||Since the oldest items are sold first, the number of records to maintain decreases.||Since the newest items are sold first, the oldest items may remain in the inventory for many years. This increases the number of records to be maintained.||All types of inventory.|
|10. Fluctuations in price||Only the newest items remain in the inventory, and the cost is more recent. Hence, there is no unusual increase or decrease in the cost of goods sold.||Goods from a year ago may remain in the inventory. Selling them may result in reporting unusual increases or decreases in the cost of goods.||It is fit in price fluctuation.|