discuss with examples the two methods of inventory control. Which method do you think is better for a retail store with several items of small value?
Once the system is determined, the costing method should be determined. There are four choices of costing methods.
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Average cost
- Specific unit cost
The costing method chosen to determine the cost assigned to inventory is very important because it directly impacts the balance sheet, income statement, and the statement of cash flows.
Unfortunately, the cost (price the company pays) tends to increase over time due to inflation. Occasionally, cost declines as well, but because the costs change, there are issues in valuing cost of goods sold and ending inventory.
For instance, a small corner store carries Hershey Bars and buys a box at the start of business for a cost of $.20 per bar. During the accounting period, many of the candy bars are sold, so another box is purchased and placed on the shelf along with the remaining bars from the original purchase. The new box is purchased at a cost of $.25 per bar. Now, there are bars on the shelf at more than one cost. When the next bar sells, what amount is taken out of inventory and recorded as cost of goods sold? Is it $.20, $.25, or another amount? The choice of costing method determines this.
- FIFO is an acronym for first in, first out. This means that when the next Hershey Bar is sold, $.20 will be taken out of inventory and recorded as cost of goods sold because it represents the cost of the first items received and still on the shelf. With this method, each bar sold will be recorded with a cost of $.20 until the units that had remained from the first case are sold. The following units will then be sold at costs of $.25, and so on. This method results in the lowest (earliest) costs being recorded as cost of goods sold, which will produce the highest gross profit and net income. This method leaves the highest cost items in the ending balance of inventory and is reported on the balance sheet.
- LIFO is an acronym for last in, first out. This is the opposite situation when the candy bars are sold. The next unit sold will be taken from inventory at the last cost, $.25 and is recorded as cost of goods sold. This method results in the highest cost of goods sold and the lowest gross profit and net income. The lowest cost items remain in the ending inventory balance and are reported on the balance sheet.
- When using the weighted-average cost method, a weighted average unit cost is calculated each time a new box is purchased. To calculate a weighted average, the quantity of units must be known. Let’s say that in this example there were five bars remaining at $.20, and the new case was for another 20 bars at $.25. The average is calculated as follows: <(5 * .20) + (20 * .25)>/25 units = $.24 average cost per unit. When the next bars are sold, they will be removed from inventory at $.24 per bar. They will continue to be removed from inventory at $.24 until all are sold or another box is purchased, whichever happens first. This method produces cost of goods sold and inventory balances that are between the other two methods.
- The specific identification method is used for high-end unique inventory items. An example would be a jewelry store. A batch of diamond rings are purchased, each with a unique quality of diamonds and a unique setting. Each has a different cost based on these features. This method involves tracking the specific cost of each unit of product by giving each a unique code. When a specific ring sells, its specific cost can be determined and used to reduce inventory and record cost of goods sold. The results of this method will vary depending on which items sell. Now generalities can be made about the results.