This article uses Cerf Company data to demonstrate the calculations needed to apply three cost flow assumptions and the specific identification method.
This scenario warrants three points.
First, simply six purchases every year is too simple. However, these methods work for more complex real-world purchasing patterns.
Second, we use the periodic inventory system, which does not need us to track sales dates for cost flow.
Sales dates matter in everlasting inventory.
Third, GAAP allows these procedures as alternatives.
The FIFO technique assumes that the first items purchased are the first things sold, and the ending stocks are the latest goods purchased.
The cost of items sold during the period is calculated using FIFO.
However, the FIFO technique first calculates the cost of the ending inventory, from which the cost of items sold can be calculated.
As seen in the figures, the 600 ending inventory units include:
29 November: 250 units bought
350 of 400 units bought on 27 September
This method is rarely employed because enterprises sell more things than they have at the end of the year, making it easier to count what is left.
After 2018, $2,785 becomes the starting inventory in 2019.
This inventory has two levels of 250 and 350 units purchased at various costs, however they are rarely needed.
Stock can be moved forward as 600 units for $2,785. Under FIFO, these commodities will be sold first in the next year, thus we can integrate these two tiers.
They become part of the commodities sold, therefore the cost is part of a huge pool where layer identification is not significant.
Many commodities travel on a FIFO basis, but this is not a requirement for its use.
Consider a hardware store’s huge nail barrel. New nails are placed on top of older nails in the barrel, and the top nails are sold first.
The nails move last-in, first-out. However, the hardware store management can price inventories using FIFO.
LIFO pricing assumes the cost of the last things purchased is the cost of the first goods sold.
The ending inventory cost is the cost of the earliest purchases.
Based on Cerf Company data, LIFO ending inventory costs $2,410 and cost of goods sold $8,030.
As shown above, the 600 ending inventory units are considered to include:
500 initial inventory units
Buy 100 units starting January 24.
As in the preceding case, we may calculate the cost of goods sold without removing the ending inventory of $2,410 from the goods available for sale of $10,440.
Separate layers of ending inventory costs are needed when using LIFO.
In our scenario, the next period’s inventory is carried forward in two tiers of 500 units at $4.00 and 100 units at $4.10.
If the next year’s ending inventory falls below 600 units, the 24 January purchase’s 100 units would be included in the cost of products sold before the beginning inventory’s 500 units.
After being added last, the 24 January layer is sold first under the LIFO approach since inventory reduces in sequence.
To calculate the weighted average unit cost of items available for sale in 2020, the beginning inventory of 600 units at a total cost of $2,610 is included.
A Specific Identification
Sometimes it’s practical to determine the purchase cost of the ending inventory’s items.
An auto dealer may keep track of the cost of each car sold and the number of cars in inventory at year’s end.
Antique stores, furniture stores, and coin and stamp dealers are also examples.
Depending on costs and benefits, other firms may keep similar records.
Assume the Cerf Company can identify the 600 goods in the ending inventory as from the purchases below.
Thus, ending inventory costs $2,640 and items sold cost $7,800.
The specific identification approach has theoretical issues as well as practical issues with tracking inventory costs.
Say a company makes one sort of item that is identical (fungible). Wheat and other commodities are fungible.
Such products’ buyers don’t care which item or lot they buy, so the firm’s management can choose any lot.
A buyer of 10 ounces of gold doesn’t care whose lot it comes from as long as it’s all the same quality. This allows the firm’s management to sell gold from any lot.
Management can control income by selling lots with acquisition expenses.
Assume Cerf Company management intends to maximize revenue this year.
The firm sells the $4.00 and $4.10 items with the lowest acquisition expenses.
To reduce income, management will sell products with the highest purchase prices next year.
Management could make such judgments annually without a clear pattern.
Thus, it can control business income.