8 - Basic Concepts of Inventory Costing Methods

Summary

This video from principlesofaccounting.com delves into the intricacies of inventory costing, covering fundamental methods such as FIFO, LIFO, and weighted average. It explains the allocation of costs between cost of goods sold and ending inventory, emphasizing the impact of these allocations on gross profit and balance sheet values. The video also clarifies which costs should be included in inventory valuation, such as invoice and freight costs, while excluding non-inventoriable costs like interest and storage. It highlights the importance of adopting a consistent costing method and the independence of cost flow assumptions from the physical flow of goods, using the example of milk to illustrate this point. The video concludes by encouraging viewers to explore the textbook for further mathematical examples and a deeper understanding of these concepts.

Takeaways

• 📚 The module introduces the basic concepts of inventory costing, including FIFO, LIFO, and weighted average methods.
• 🔢 The total goods available for sale is calculated by adding the beginning inventory to the purchases.
• 🧮 The allocation of the cost of goods available for sale determines the cost of goods sold and the ending inventory.
• 💵 Allocating more to cost of goods sold results in lower gross profit and inventory values on the balance sheet.
• 🚫 Inventory should include only costs necessary for resale, excluding carrying costs like interest, storage, or insurance.
• 🛒 Costing methods are necessary because each unit of inventory may have a different cost due to varying purchase prices.
• 🔄 The cost flow assumption is an accounting method to assign costs to inventory, unrelated to the physical flow of goods.
• 🔝 Under FIFO, the oldest costs are assigned to cost of goods sold, and the most recent to ending inventory.
• 🔝 Under LIFO, the most recent costs are assigned to cost of goods sold, and the oldest to ending inventory.
• 🔄 The weighted average method calculates cost of goods sold and ending inventory using an average unit cost.

Q & A

What are the three basic inventory costing methods discussed in the transcript?

The three basic inventory costing methods discussed are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the weighted average method.

What is the purpose of allocating costs between cost of goods sold and ending inventory?

The purpose of allocating costs is to determine how much of the cost of goods available for sale is included in the ending inventory for the balance sheet and how much is reported as cost of goods sold on the income statement.

How does increasing the cost of goods sold by $1 affect the gross profit and the balance sheet?

Increasing the cost of goods sold by $1 results in a decrease in gross profit because it is calculated as sales minus cost of goods sold. It also decreases the asset value of inventory on the balance sheet, while maintaining balance sheet equality.

What costs should be included in ending inventory?

Ending inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for resale, such as invoice price and freight cost.

What costs are excluded from ending inventory?

Carrying costs like interest on financing inventory, storage, or insurance costs, as well as selling costs, freight out costs, salesperson commissions, and similar expenses are excluded from ending inventory.

Why do companies need to adopt an inventory costing method?

Companies need to adopt an inventory costing method to allocate the cost of all units consistently from year to year to the units in ending inventory and the units sold, or cost of goods sold.

What does the FIFO method assume about the flow of costs?

The FIFO method assumes that the oldest costs are matched against revenue and assigned to cost of goods sold first, while the most recent costs are assigned to ending inventory.

How does the LIFO method differ from the FIFO method?

The LIFO method is the opposite of FIFO; it matches recent costs against revenue and assigns them to cost of goods sold, while the oldest purchases remain in inventory.

What is unique about the LIFO method in the context of global accounting practices?

LIFO is uniquely a United States-based accounting method, and many parts of the world do not recognize or allow the LIFO method.

How does the weighted average method calculate the cost of goods sold and ending inventory?

The weighted average method calculates the cost of goods sold and ending inventory by dividing the total cost of goods available for sale by the total units, then applying this average cost to the units sold and the units in ending inventory.

Why is it important for accountants to track inventory costs using a cost flow assumption?

It is important for accountants to track inventory costs using a cost flow assumption because it helps to maintain consistency in inventory valuation and financial reporting from year to year.