Inventories and the Cost of Goods Sold

Accountants may use an approach called Specific Identification, or they may adopt a cash flow assumption. Either of these approaches is acceptable. Once an approach has been selected, however, it should be applied consistently in accounting for sales of this particular type of merchandise.

Specific Identification:

The specific identification method can be used only when the actual costs of individual units of merchandise can be determined from the accounting records. The actual cost of this particular unit then is used in recording the cost of goods sold.

Cash Flow Assumption

If the items in inventory are homogeneous in nature, it is necessary for the seller to use the specific identification method. Rather, the seller may follow the more convenient practice of using a cost flow assumption. Using a cost follow assumption is particularly common where the company has a large number of identical inventory items that were purchased at different prices.

Three cost flow assumption are in widespread use:

·         Average cost:

·         First-In-First-Out(FIFO)

·         Last-In-First-Out(LIFO)

The cost flow assumption selected by a company need not correspond to the actual physical movement of the company’s inventory. When units are identical, it does not matter which units are delivered to the customers in a particular sales transaction. Therefore in measuring the income of a business that sells units of identical merchandise, assumption considers the flow of costs to be more important that the physical flow of the merchandise. 

Average Cost Method

When using average cost, assign the average cost of the goods available for sale to cost of goods sold.  The average cost is determined by dividing the cost of goods available for sale by the units on hand. 

Example:

On August 1^st and 3^rd, TBC purchases inventory.  On August 14^th, they sell 20 bikes for 130 each. 

First, TBC needs to compute the average cost of the items in inventory.  They do this by dividing the cost of goods available for sale of $2,500 by the total units in inventory of 25. The average cost per unit is $100.

Then, to determine the Cost of Goods Sold for August 14^th, multiply the number of units sold by the average cost.  This calculation determines that the Cost of Goods Sold for August 14^th is $2,000. 

Entries will be:  

After this sale, TBC has 5 units in inventory at an average cost of $100 each.

First-In-First-Out Method 

The first in first out method, often called FIFO, is based on the assumption that the first merchandise purchased is the first merchandise sold. 

 

Example:

TBC makes 2 purchases on August 17^th and August 28^th. On August 31^st, TBC sells 23 bikes.

To determine the cost of goods sold on August 31^st using FIFO, TBC takes the cost of the 5 remaining units from the August 3^rd purchase at $106 each.  Then, they move down to the next purchase on August 17^th and take the cost of 18 units at $115 dollars each. The Cost of Goods Sold for August 31^st is $2,600. 

Entry will be:

After the August 31^st sale, TBC has 12 units in inventory: 2 units at $115 each and 10 units at $119 each.

Last-In-First-Out Method

 

When using the Last-in, First-out (LIFO) method, we assign the most recent costs to the units sold.  That leaves the older costs to be used to value ending inventory.

Example:

TBC makes two purchases on August 17^th and August 28^th. On August 31^st, TBC sells 23 bikes.

Using LIFO, TBC takes the cost of  the 10 units from the most recent purchase on August 28^th at $119 each.  Then, they move up to the next most recent purchase on August 17^th and take the cost of 13 units at $115 each.  The Cost of Goods Sold for August 31^st is $2,685.

Entry will be:

 

After the August 31^st sale, TBC has 12 units in inventory: 5 units at $91 each and 7 units at $115 each.