Inventory Costing Methods

Both systems start from the same idea, shown in the cost flow below. Beginning inventory plus purchases gives the cost of goods available for sale. That pool of cost must end up in one of exactly two places: Cost of Goods Sold on the income statement, or Merchandise Inventory on the balance sheet. A cost formula just decides which costs go where.

• Specific identification: track the actual cost of each individual item, often by serial number. Required for items that are not interchangeable, such as custom canoes, vehicles or fine jewellery. Impractical for thousands of identical backpacks.
• FIFO (first-in, first-out): assume the oldest costs leave first. Cost of goods sold uses the earliest costs; ending inventory is made of the most recent costs.
• Weighted average (periodic): divide total cost of goods available by total units available, and apply that one average to both units sold and units on hand.
• Moving average (perpetual): recompute the average after every purchase, and cost each sale at the average at that moment.

Check the FIFO card: cost of goods sold $8,900 plus ending inventory $2,500 is $11,400, the cost of goods available. With the periodic formula: $\$2,000+\$9,400-\$2,500=\$8,900\text{.}$ Under FIFO, perpetual and periodic always agree, because the oldest units are the oldest units no matter when you look.

Weighted average (periodic): ending inventory is $100\times \$22.80=\$2,280$ and cost of goods sold is $400\times \$22.80=\$9,120$. Again the two add to $11,400. Moving average (perpetual) recomputes the average after each purchase, so its answer is slightly different. Keep unit costs to four decimal places and round dollar amounts to the cent.

FA32 – Inventory Costing Methods Explained - FIFO, LIFO, Weighted Average

LIFO (last-in, first-out) assumes the newest costs leave first. For the backpacks, periodic LIFO would charge the last 400 units bought to cost of goods sold, $200\times \$25+200\times \$22=\$9,400\text{,}$ leaving the oldest 100 units at $20 in ending inventory, $2,000. LIFO is allowed in some other countries, notably the United States, so you will see it in American financial statements. It is NOT permitted under IFRS or ASPE, so Canadian companies use specific identification, FIFO or a weighted average cost formula. The main criticism: when prices rise for years, LIFO leaves inventory on the balance sheet at very old, unrealistically low costs.

When costs are rising, FIFO sends the old, cheap costs to cost of goods sold, so it reports the LOWEST cost of goods sold, the HIGHEST gross profit and net income, and the HIGHEST ending inventory, which is close to current replacement cost. Average cost lands in between. When costs are falling, everything flips: FIFO now sends the old, expensive costs to cost of goods sold and reports the lowest profit. Over the whole life of a business the total cost charged is the same; the methods only shift profit between periods. Higher reported income also means higher income tax in that period.

Lower of cost and net realizable value (LCNRV). Inventory should never be reported at more than the business expects to get for it. Net realizable value is the estimated selling price minus the costs needed to sell it. If NRV falls below cost (goods become damaged, out of style, or the market price drops), inventory is written down to NRV, usually item by item or by groups of similar items, and the loss is charged to cost of goods sold. Under both ASPE and IFRS, if NRV later recovers, the write-down is reversed, but never above the original cost.