Module 8 - Inventory Costing Methods Notes

Introduction to Inventory Costing Methods

  • Module 5 covered inventory basics (what is/isn't inventory, tracking, purchases, and sales).

  • This module focuses on:

    • Determining which items have been sold vs. remain in inventory.

    • Assigning dollar values to ending inventory.

    • Accounting for inventory shrinkage (damage, theft).

    • Accounting for drops in inventory value.

Topics and Learning Objectives

  • Topics:

    • Inventory Costing Methods.

    • FIFO (First-In, First-Out) method for Cost of Goods Sold (COGS) and Ending Inventory calculation.

    • Physical Inventory Count.

    • Recording Inventory Shrinkage.

    • Recording Reduction in Inventory Value.

  • Learning Objectives:

    • List and explain the three inventory costing methods and determine when to use each.

    • Calculate ending inventory and COGS using FIFO.

    • Explain the importance of annual inventory counts.

    • Determine and adjust for count differences.

    • Calculate adjustments for declines in inventory value.

Inventory Costing Methods

  • How Often Does the Cost of Purchasing Inventory Change?

    • In reality, inventory costs vary almost every time you purchase it.

    • Many factors affect the cost of inventory purchases.

  • How Important Is It for Businesses to Know the Cost of Their Inventory?

    • Knowing the cost of inventory is extremely important for decision making.

    • Understanding the cost of inventory allows business owners to consider such things as changing suppliers, using different shipping companies, or reducing other operating expenses to allow for similar profitability in the business overall.

    • Business owners might also try to negotiate better pricing from existing suppliers.

    • Without detailed information about inventory costs it would be difficult for merchandisers to run their businesses so that they can make the profit they want.

  • Tracking Inventory Costs

    • In Module 5, inventory purchases were added to the Inventory account, a current asset account on the balance sheet.

    • Each purchase was added as a total amount for the whole purchase, which gave no information about the per-unit cost of inventory.

    • In Module 5, for simplicity, the cost of inventory was often kept constant (never changing).

    • But, since inventory costs do change with every purchase, the unit cost of inventory is important information, needed so that businesses can record all inventory transactions at the correct amount.

    • That information can also be used by you, the owner, to make decisions, such as what the selling price of each item should be.

  • Businesses use inventory tracking systems.

    • You were already introduced to one such system: the perpetual inventory system you used in Module 5.

    • However, the perpetual inventory system does not track individual prices for inventory, which is required for good decision making.

    • To better track per-unit costs of inventory, businesses use inventory costing methods.

    • These systems assign (give) costs to each unit of inventory.

    • They also determine the cost of goods sold (because inventory costs are transferred (moved over) to cost of goods sold when the inventory is sold.

Inventory Costing Methods Overview

  • Different businesses use different methods for various types of inventory.

  • Three main inventory costing methods:

    • Specific Identification

    • Average Cost

    • First-In, First-Out (FIFO)

Specific Identification Method

  • Cost of every single item of inventory is tracked and tagged.

  • The cost of each item can be determined at any time.

  • When sold, the specific item's cost moves from Inventory to Cost of Goods Sold.

  • Drawbacks:

    • Expensive and time-consuming due to detailed record-keeping.

    • Only suitable for unique items or those with serial numbers.

  • Example: Used Car Dealership

    • Red car: 10,000

    • Blue car: 11,000

    • Green car: 12,000

Specific Identification Method - Example Entries to expanded accounting equation

  • Check Your Understanding (CYU6-1)

    • If all the cars are identical, why can each of them have a different cost?

    • If you sold the green car for 20,000 cash, what would your entry be?
      *Cash and Sales Revenue both increase by 20,000. Inventory decreases and Cost of Goods Sold increases by 12,000.

    • Sales Revenue: 20,000

    • Cost of Goods Sold: 12,000

    • Gross Profit: 8,000

    • Gross Profit Ratio: 40% (8,000 ÷ 20,000).

    • The inventory remaining on the balance sheet would be 21,000 (the red car at 10,000 and the blue car at 11,000).

April Purchases Example

  • April 3: 15,500

  • April 14: 14,200

  • April 18: 16,200

  • April 20: 13,800

  • Items from April 14th and 20th are sold for 22,000 each

    • Sales revenue is 44,000 and cost of goods sold is 14,200 + 13,800 = 28,000, so your gross profit is 44,000 - 28,000 = 16,000.

    • 15,500 + 16,200 = 31,700.

When to Use Specific Identification

  • Businesses selling a small number of expensive, easily identifiable products.

    • Examples: original art, cars (VIN), diamonds.

  • Not suitable if the cost of tracking each small item is too high.

Average Cost Method

  • Used for homogeneous items (all the same).

    • Example: 12-pack of Coca Cola®.

  • Average cost is recalculated every time a new car is purchased.

Average Cost Method - Average cost Red and blue car Example

  • Red car, 10,000

  • Blue car, 11,000

  • Total cost of two cars = 21,000

  • Average cost per car = 10,500 (21,000 ÷ 2 cars).

    • Average cost per car = 10,500 each

    • What is the gross profit for April?

    • What is the value left over in your inventory account on the balance sheet?

Average Cost Method - Average cost Three Car Example

  • Red car worth 10,000

  • Blue car worth 11,000

  • Green car worth 12,000

  • Total cost of 3 cars = 33,000

  • Average cost per car = 11,000 (33,000 ÷ 3 cars)
    The entry to “Inventory” and “Cost of goods sold” would be for the average cost of 11,000!
    *What would happen to the gross profit on the sale now, when you use average cost?
    *Blue car sell for 20,000. Partial Income Statement Average Cost Method*Sales 20,000 *Cost of goods sold 11,000 *Gross Profit 9,000

Average Cost Method - Blue Car Sale

  • Example: What About Another Example of Average Cost?

    • Lower average cost now because the 2 cars did not cost as much.
      Sell the blue car for 20,000. The gross profit ratio is also different: 45% (9,000 ÷ 20,000). It was 40% before.

    • Gross Profit 9,500

    • gross profit ratio? It is 47.5%!!!

  • Prices were smooth, and the price varied based on how much you paid.

  • Total cost: 10,000 + 11,000 + 12,000 = 33,000. No matter which method you use the total COST of your three cars is exactly the same.
    Calculations are perfect

Understanding Moving Costs From Inventory

  • Clarification of Moving Costs

  • Each method moves costs from inventory to cost of goods sold using a different allocation method.

    • Specific Identification: Move EXACTLY the cost of that inventory item over to cost of goods sold, and what is left on the balance sheet is the EXACT value of the inventory items left over (what you actually paid for those inventory items).

    • Average Cost: Move the AVERAGE COST of each item of inventory over to the cost of goods sold, and what is left on the balance sheet is the AVERAGE COST of the items left over.

      • Either way, once you have sold all three cars, cost of goods sold will be 33,000 and inventory will be zero until you purchase more cars.

Check Your Understanding (CYU6-3)

  • You purchase four inventory items on the following dates and for the following amounts. Your business uses the average cost method. (One item is purchased on each date for the amount indicated.) You sell one item on April 15 and another item on April 19 for 22,000 each.
    *Hint: remember that every time you buy new inventory you have to calculate a new average cost.

  • Total 15,500 + 14,200 = 29,700. Average is 29,700 ÷ 2 = 14,850.
    Cash and Sales Revenue increase by 22,000 each. Inventory decreases and Cost of Goods Sold increases by 14,850.Remaining inventory is one item at 14,850

  • Total is 14,850 + 16,200 = 31,050. Average is 31,050 ÷ 2 = 15,525.
    Cash and Sales Revenue increase by 22,000 each. Inventory decreases and Cost of Goods Sold increases by 15,525. Remaining inventory is one item at 15,525.

  • Total is 15,525 + 13,800 = 29,325. Average is 29,325 ÷ 2 = 14,662.50.

Choosing Between Inventory Costing Methods

  • Specific Identification: Use for unique items with high dollar values to track exact gross profit.

  • Other Inventory: Choose between FIFO and Average Cost based on which best matches the physical flow of goods.

FIFO (First-In, First-Out) Method

  • Use if the oldest items are sold first.

  • The business would appropriately value their inventory at the end of the period.

  • The physical flow of goods, goes oldest out the door first.

    • Controlled by the owner and newest still available for future sales.

  • The method matches the physical flow of goods.

    • Example Floral Business

Average Costing Method

  • Customers can choose what they want. Nothing will spoil. The business does not control the physical flow of inventory.

  • The customer is in control of the physical flow of goods based on what they choose to buy.

  • Example Hardware Store
    Here is a list. Consider WHY the business would use the method and HOW they are able to control their inventory so that the method they use ties into the physical flow of goods.Clothing store *Computer store *Art gallery *Antique store *Supermarket *Hardware store
    *Car dealership would certainly use specific identification for the cars on the lot, but probably average cost for the parts department.

Methods You Need to Know

  • You need to understand the three methods (be able to describe them, discuss differences and similarities).

  • You also need to be able to assign a method to a business depending on what type of inventory they sell (CYU6-4 is a good example of the type of question you will see on the final exam).

  • However, for any calculation problems you only need to know the FIFO costing method.
    *Most important thing for you to understand is the WHY behind the calculations (why would you need to know this?)

About FIFO.

  • Assets must be equal to their future benefit to the business.

  • When businesses use the FIFO costing method, the value of their ending inventory on the balance sheet is equal to their most recent purchases and that value is closer to the future benefit of the inventory than average cost.

  • The value is also closest to replacement cost.
    *Calculation ending inventory and cost of goods sold using the FIFO costing method.

FIFO Example: Bernard Ltd. Tool Business

  • Calculate COGS and ending inventory using a perpetual inventory system.

  • Set up a chart with columns for purchases, COGS, and inventory on hand.

  • Input beginning inventory in the Inventory On Hand section.

  • Opening inventory multiply the quantity (number of units) by the unit cost to get the total cost (15 units x 40 per unit = 600).

Order To Record and Calculate FIFO

  • Record the purchase for November 5 (160 units x 45 per unit = 7,200) into the inventory control system.

  • You record the entry into the inventory control system (using FIFO) first. This amount is then used to update the perpetual inventory system in the expanded accounting equation.

  • Then record the purchases and sales in chronological order, both in the perpetual inventory system using the expanded accounting equation and account names, as well as in your inventory control system using FIFO!

  • List both opening inventory and purchases in the rows for November 5.

  • The total of 7,800 should be entered as a single number – don’t write the 600 and the 7,200 separately in the On Hand column.
    Your chart must ALWAYS be true. If they don’t match then you have made a mistake somewhere along the way!

Tracking Inventory and Its Importance

  • The records tell you not only how many units you have (175 in total) but also how much they cost (40 originally but now 45 for the latest shipment).

  • That information helps you to find out why the price is increasing.

    • Shipping is getting more expensive: you would want to research different shipping companies to see if you can get it shipped cheaper.

    • The supplier no longer offers a discount or has increased their prices: you might want to look for new suppliers.

    • Exchange rate is getting worse.

Bernard LTD Example Sale

  • On November 7 you sold 140 hammers to TownTools Ltd. for 90 each.

  • 15 units from opening inventory, times the unit cost of 45, are input into the Cost of Goods Sold column (15 units x 40 = 600).

  • You sold 140 units and you have already used 15 from the beginning inventory so you need 125 units more (140 units - 15 units = 125 units).

  • You take the 125 units from the November 5 purchase. On November 5 you paid 45 per unit, so you multiply 125 units x 45 per unit = 5,625.

  • Calculate the cost of goods; you add the 600 from beginning inventory plus the 5,625 from the November 5 purchase to get a total 6,225.

  • The 160 units purchased on November 5 less the 125 units assigned to the cost of goods sold account for this sale = 35 units at 45 each = 1,575 of inventory is left.

Sales and Expanded Accounting Equation

  • 1. 600

  • 2. 200 7,200Inventory Levels Analysis Using the Example
    $12,600 - $6,225 = $6,375. That is a gross profit ratio of 50.6%!
    Based on your predictions about future sales you can now decide on what you should buy.

Tracking New Purchases

  • On November 12 you purchased 110 hammers at 46 each (110 units x 46 per unit = 5,060).

  • This allows you to always know exactly what inventory you have on hand and how much the different groups of inventory items cost.

  • You now have 145 units on hand at a total cost of 6,635.

  • Hopefully your inventory levels are high enough to cover upcoming orders but not so high that you hold your inventory for too long.

  • Using your records you can analyze the past to help you decide on what to do in the future.

Sales Example

  • Use oldest inventory first.

  • Next you have to figure out how many units you have left.

Calculate the gross profit for this sale: 9,200 - 4,565 = 4,635.*
The first sale is 59.6% (6,375 / 12,600) and on the second sale is 50.4% (4,635 / 9,200).
Checking Calculations

  • 1. Opening inventory, 25 parts at 8 each

  • 2. Purchased 120 parts at 9 each

  • 3. Sold 90 parts for 17 each

  • 4. Purchased 80 parts at 9.50 each

The cost of goods available for sale (12,260 in this example).

Analyzing Calculations

  • Now, to check if you have made any mistakes, you add the cost of goods sold (10,790) to the ending inventory (2,070) and it MUST equal the cost of goods available for sale (12,260 purchases + 600 opening = 12,860).

  • 12,860= 10,790 + 2,070.

Stakeholders and Inventory

  • Managers/business owners needs to know how much inventory a business has throughout the year.

  • Customers may go elsewhere to get what they want.

  • Too little inventory can be bad but too much inventory may be just as bad.
    This allows the business can keep their costs down and avoids the problem of inventory becoming damaged or obsolete.
    *This system aims to have just enough inventory on hand so customers have it when they want it but not so much that it sits on the shelf and gathers dust!

Analyzing the Calculation of Inventory

  • 1. Opening inventory, 25 parts at 8 each.

  • 2. Purchased 120 parts at 9 each.

  • 3. Sold 90 parts for 17 each.

  • 4. Purchased 80 parts at 9.50 each.

  • 5. Sold 105 parts for 17 each.

Units available for sale are 25 + 120 + 80 = 225.

Sales were 90 + 105 = 195, so ending inventory is 225 – 195 = 30 units.
These come from the most recent purchase, so 30 x 9.50 = 285.

Goods available for sale was (25 x 8) + (120 x 9) + (80 x 9.50) = 2,040.

Since ending inventory (i.e., cost of goods NOT sold) was 285, cost of goods sold was 2,040 - 285 = 1,755.

Keeping Inventory Records

  • The mistake that students make most often is putting the selling prices instead of the cost prices on the inventory control chart.

  • The 17 selling price is only needed to calculate the revenue on the accounting chart, and gross profit later. It never appears on the inventory control chart.

Physical Inventory Count Purpose

  • Even if the records are kept up to date, what your records say and what is actually there may be different.

  • Reasons for Discrepancies:

    • Shrinkage (theft).

    • Human error.

    • Damages.

    • Obsolescence.
      Businesses must count all inventory once a year so that they can check how accurate their FIFO costing system is.

What To Do For Physical Inventory Count

  • First, the business’s employees will be asked to help count every single item of inventory that is on hand.

  • Second, the count has to be adjusted for inventory in transit.

Determining Ownership of In-transit Inventory

  • Shipping terms determine ownership.

  • FOB (Free on Board) shipping point: buyer owns goods in transit.

  • FOB destination: seller owns goods in transit.

Including Inventory in Transit

You, the buyer, own it, then you have to include it in your inventory records at year end (so you can include it on your balance sheet) even though you don’t, physically, have the inventory yet!
Example On December 28, Year 1 Molson Brewing Co. ships 100 cases of beer to the Beer Store. The terms are FOB shipping point and the Beer Store receives the cases on January 3, Year 2.The Beer Store would include the cases of beer in their inventory on December 31 because they are the buyer and since the terms are FOB shipping point, this means that the buyer owns the goods while they are in transit.
As noted in Module 5, for every transaction, you are either the shipper or the destination.

Physical Inventory Count To Balance Sheet

  • You must include the value of the inventory you own in transit as part of your inventory value on your balance sheet, under current assets.
    Check the count against your inventory records.

  • 1. On December 27, Year 1 Davidson Publishing Ltd. ships 100 books to the Book Store.The terms are FOB destination point and the Book Store receives the books on January 4, Year 2.

  • 2. On December 28, Year 1 Mohammad Publishing Ltd. ships 50 magazines to the Book Store. The terms are FOB shipping point and the Book Store receives the magazines on January 3rd, Year 2.

  • 3. On December 27, Year 1 Lingner Publishing Ltd. ships 75 fiction books to the Book Store. The terms are FOB destination point and the Book Store receives the books on December 31, Year 1.

Adjustment of Inventory for Differences Example

  • Let’s assume that the inventory count comes back, and it turns out you only have 42 units on hand.
    Where are the other 3 units?
    Show it on your chart.
    you have to make an entry to your accounting system so that your inventory account is updated

What is inventory Shrinkage?

  • 1. Theft, breakage, or human error in shipping, receiving, counting or recording.

  • 2. One cost and one are missing.

Reduction in Value of Inventory

This is the final check every business does for every single item of inventory that they carry. They do this right before the financial statements are produced so that the value of inventory is equal to its future benefit to the business. Value of inventory against the market price.The fact is, sometimes businesses have inventory which they just can’t sell.
might call it Inventory Losses.

Business and Inventory Value

  • For example, Blackberry’s Playbook® was estimated to cost the company 271 to manufacture. Although it was originally priced to sell at 599, the price soon dropped to 499, then 299, and finally 199. The final selling price of 199 was 72 lower than the historical cost (what it cost to create the Playbook®).

Recoding The Market

  • Determine Is there a market for this product?

    • If so, how much can you sell that product for today?

    • Can you sell it for more than it cost you?
      *Say that, at the end of the period, Bernard’s management reviews their inventory records
      Because your inventory does not have a future benefit equal to the current value.

Stakeholders and Check on Market Price

  • Important to creditors because creditors like the bank use the information from the financial statements to make decisions about how much money to lend a business.

  • Danier Leather, on their June 29, 2013 financial statements, stated that they were recording a 1.6 million dollar write-down of their inventory because the selling price of their inventory was less than the cost they paid to purchase the inventory.

  • 1. The 25 remain in stock, costing 70 each. As they can now be sold for only 50, the inventory must be valued at 25 x 50 = 1,250. The adjustment would be 25 x ($70 - $50) = 500.

Note: non-graded activities. To further confirm what you have learned in this module, you should work through the following
Students’ most common errors on midterms and final exams are forgetting to take into account the opening inventory when completing the chart for the FIFO costing method; and entering the selling price instead of the cost into the cost of goods sold column in the FIFO chart.