inventory cost

Once companies determine the number of inventory units, they apply unit costs to the quantities to calculate the total cost of inventory and the cost of goods sold. If companies can identify in particular which particular units are being sold and which are still in ending inventory, they can use the inventory cost-specific identification method. Using this method, companies can accurately determine ending inventory and cost of goods sold. Requires businesses to keep records of the original cost of each individual inventory item. Traditionally, specific identification was used to keep records of products like cars, pianos, or other expensive items from the time of purchase to the time of sale, much like barcodes are used today. Today, this practice is somewhat rare, as most companies engage in cost flow assumptions.

Cost flow assumptions differ from specific identification in that they assume cost flows that may not be related to the physical flow of goods. There are three assumed methods which include (FIFO), (LIFO) and (Cost Average). The company’s management generally selects the most appropriate cost flow method.

The FIFO (first in, first out) method assumes that the first goods purchased are the first to be sold. It is often parallel to the physical flow of goods. Therefore, the costs of the first goods purchased are the first to be recognized in determining the cost of goods sold. Ending inventory is based on the prices of the most recently purchased units. Firms find the cost of ending inventory by taking the unit cost of the most recent purchase and working backwards until all units of inventory cost. For management, higher net income is an advantage. It makes external users view the company more favorably. Also, management bonuses, if based on net income, will be higher. Therefore, when prices go up, companies tend to prefer to use FIFO because it generates higher net income. A great advantage of the FIFO method is that, in a period of inflation, the costs assigned to the ending inventory will approximate its current cost.

The LIFO (last in, first out) method assumes that the last goods purchased are the first to be sold. LIFO never matches the actual physical flow of inventory. The costs of the last goods acquired are the first to be recognized in determining the costs of goods sold. Ending inventory is based on the prices of the oldest units purchased. Companies find the cost of ending inventory by taking the unit cost of the first goods available for sale and working up to the cost of all inventory units.

The average cost method allocates the cost of goods available for sale based on the weighted average unit cost incurred; it also assumes that the goods are of a similar nature. The company applies the weighted average unit cost to the units on hand to determine the cost of ending inventory. You can check the cost of goods sold with this method by multiplying the units sold by the weighted average unit cost.

Each of the three assumed cost stream methods is acceptable for use. 44% of major US companies use the FIFO method. They include companies like Reebok International Ltd. and Wendy’s International. 33% use the LIFO method, including companies like Campbell Soup Company, Kroger’s, and Walgreen Drugs. 19% use the Average Cost method including Starbucks and Motorola. Some companies may use more than one. Black and Decker Manufacturing Company uses LIFO for domestic inventory and FIFO for foreign inventory. The reasons companies adopt different inventory cost flow methods are varied, but generally involve three factors. First, income statement effects, second, balance sheet effects, and lastly, tax effects.

Whichever cost stream method a company chooses to use, it must use it consistently from one accounting principle to another. This approach is often referred to as the consistency principle, which means that a company uses the same accounting principles and methods from year to year. Consistency improves the comparability of financial statements over time periods. Using FIFO one year and LIFO the next would make it difficult to compare the net income of the two years.