Accountancy - Inventory notes

This lesson introduces you to the cost flow assumption
methods of specific identification: FIFO, LIFO, and
weighted average. You will also learn to compute
inventory in a perpetual system using the methods of
FIFO, LIFO, and weighted average.
Perpetual Inventory Systems
Mega Irrigation, a large irrigation wholesale store, is
looking to switch from a periodic inventory system ,
where they update financial records for merchandise
transactions at the end of a period, to a perpetual
inventory system , which will allow them to continually
update records for merchandise transactions.
Management at Mega Irrigation believes that this will
allow them to keep more accurate and up-to-date
records of their inventory that is available to be sold to
their customers and what specific inventory has already
been purchased. The perpetual system will tell Mega
Irrigation the exact amount of inventory on hand at all
times and what they need to restock to meet customer
demand.
Inventory Valuation
Perhaps the most significant goal of accounting for
inventory is to have an accurate assessment of costs
and sales. Inventory valuation allows a company to
provide a monetary value for items that they have in
their inventory. This information permits a company to
properly evaluate expenses and revenues on their
financial statements so that they can make sound
business decisions.
Items contained with Mega Irrigation are constantly
being sold, restocked and in some cases changing in
cost. Because of all of these changes, Mega Irrigation
must select a cost flow assumption method to move the
cost of items within its inventory to its costs of goods
sold. The cost of goods sold refers to the cost of
merchandise sold during a specific period of time. Cost
flow assumptions under a perpetual inventory system
include:
Specific identification
First-in, first-out
Last-in, first out
Weighted average
Once implemented, Mega Irrigation must consistently
follow its stated cost flow assumption. Let's take a look
at each of these cost flow assumptions a bit more to
help Mega Irrigation choose one that is best suited for
their needs.
Specific Identification
Specific identification is used to track and cost specific
and identifiable inventory items that are either in or out
of stock on an individual basis. This is done with items
a company has identified via RFID tag, stamped receipt
date, or serial number. The system is designed to
specifically allow Mega Irrigation to identify the cost of
any inventory item with an ID number.
The best advantage with this method is the high level of
accuracy to the cost of the inventory on the balance
sheet. The disadvantage of this system is the time it
takes to enter large quantities of inventory and their
prices. Specific identification is typically a practical
solution for companies with expensive and unique
inventory. This is not the case for Mega Irrigation;
therefore, we will jump to the next cost flow assumption
method, known as FIFO.
First-In, First-Out
FIFO is an acronym for first-in, first-out and means that
the oldest inventory items are recorded as sold first.
Essentially, FIFO assumes that inventory items are sold
in the order in which they are acquired: inventory items
bought first are the first ones to be sold, and inventory
items bought later are sold later. Thus, the cost of
inventory reflected to the balance sheet represents the
cost of inventory that was purchased most recently.
As an example, let's say that Mega Irrigation has
purchased 10 sprinklers at $10.00 and 20 sprinklers at $
20.00. At the end of the accounting period, the irrigation
wholesale sells five sprinklers at $10.00. Remaining
inventory is 5 sprinklers at $10.00 plus 20 sprinklers at $
20.00 for a total remaining on the balance sheet of $
450.00.
FIFO is used by many companies but is most useful
when inventory items have a short shelf life or expiration
date and need to be sold quickly, such as in the food
industries. Because irrigation parts have a long shelf life,
we can move on to the next method, known as LIFO.
Last-In, First-Out
LIFO is a contraction for last-in, first out and assumes
that the most recent inventory items purchased are the
first ones to be sold, and inventory items purchased first
are sold last. As a result, LIFO comes closest to
matching current costs of goods sold with revenues
when compared to other cost flow assumption methods,
such as FIFO or weighted average.
Using the same example as FIFO, let's look at it using
the LIFO method. Remember Mega Irrigation had
purchased 10 sprinklers for $10.00 and then 20 sprinklers
for $20.00. At the end of the accounting period, Mega
Irrigation had sold five sprinklers at $20.00. Remaining
inventory will look like this when using the LIFO
method: 15 sprinklers at $20.00 plus 10 sprinklers at $
10.00. The balance sheet will show $400.00.
This method is generally used because it helps to
reduce income tax. A little interesting fact is that the
United States of America is the only place you can
legally use the LIFO accounting method.
Weighted Average
The final cost assumption method for Mega Irrigation to
consider is the weighted average. The weighted average
method, also known as average cost, involves
computing the weighted average cost per unit of
inventory sold at the time of sale; it assumes that
inventories are sold simultaneously.
The weighted average method is useful in companies
where inventory items are piled or combined together in
such a way that they cannot be separated to assign a
specific cost to the individual units within it. It is also a
good alternative when a company's accounting system
lacks the sophistication needed to track inventory items
under the LIFO and FIFO methods.
To calculate using the weighted average method, divide
the total cost of items in inventory available for sale by
the total number of units available for sale. Let's look at
our example. Again, Mega Irrigation had purchased 10
sprinklers for $10.00 and then 20 sprinklers for $20.00.
At the end of the accounting period, they had sold five
sprinklers. The total number of sprinklers is 30 for a cost
of $500.