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.

Outlines

00:00

📚 Introduction to Inventory Costing Methods

This paragraph introduces the topic of inventory costing, emphasizing the importance of understanding basic concepts such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and weighted average methods. The speaker outlines the challenge of allocating the cost of goods available for sale between cost of goods sold and ending inventory, which affects gross profit and balance sheet values. The allocation problem is highlighted by the example of shifting $1 from cost of goods sold to ending inventory, which impacts gross profit and inventory asset value. The paragraph also discusses what costs should be included in ending inventory, such as invoice price and freight costs, and what costs should be excluded, like carrying costs and selling costs. The need for a consistent inventory costing method is also mentioned.

05:05

🔢 Inventory Costing Methods: FIFO, LIFO, and Weighted Average

This paragraph delves into the specifics of the three main inventory costing methods: FIFO, LIFO, and weighted average. The speaker explains FIFO by using an example of nails purchased at different prices, where the oldest costs are assigned to cost of goods sold first, and the most recent costs are assigned to ending inventory. The example demonstrates how the costs are allocated when 160 pounds of nails are sold, resulting in a cost of goods sold of $166 and an ending inventory value. LIFO is then contrasted with FIFO, where recent costs are matched with revenue and assigned to cost of goods sold, leaving the oldest costs in inventory. The example provided shows how this would affect the cost of goods sold and ending inventory if the same purchases were made. The paragraph concludes with an introduction to the weighted-average method, which blends the costs to calculate both cost of goods sold and ending inventory, using an average unit cost. The speaker encourages the audience to study the textbook for further illustrations and understanding of these methods.

Keywords

💡Inventory Costing

Inventory costing refers to the methods used to assign costs to the goods a company has on hand. It is crucial for determining the cost of goods sold and the value of inventory on financial statements. In the video, inventory costing is the central theme, with the discussion focusing on how to allocate the cost of goods available for sale between cost of goods sold and ending inventory.

💡FIFO

FIFO stands for First-In, First-Out, which is an inventory costing method where the oldest inventory items are considered to be sold first. This method matches the earliest costs with revenue, thus affecting the cost of goods sold and ending inventory values. The video uses an example of nails to illustrate FIFO, where the first barrels of nails purchased are the ones sold first.

💡LIFO

LIFO stands for Last-In, First-Out, an inventory costing method where the most recent inventory items are considered to be sold first. This method can have a significant impact on financial statements, especially in times of inflation, as it matches the most recent, higher costs with revenue. The video contrasts LIFO with FIFO, showing how the costs are assigned differently, with the latest purchases considered sold first.

💡Weighted Average Cost

The weighted average cost method calculates the cost of goods sold and ending inventory by dividing the total cost of goods available for sale by the total number of units. This method results in a consistent cost being assigned to each unit sold and remaining in inventory. The video explains this method using the example of nails, where the total cost is divided by the total pounds to get an average cost per pound.

💡Goods Available for Sale

Goods available for sale is the total amount of inventory available to be sold, which is calculated by adding the beginning inventory to the purchases made during the period. This figure is essential for inventory costing as it determines the pool of goods from which costs are allocated. The video mentions this concept as the starting point for deciding how much goes to ending inventory or cost of goods sold.

💡Cost of Goods Sold

Cost of goods sold (COGS) represents the direct costs attributed to the production of the goods sold during a period. It is a critical component of the income statement, as it is subtracted from sales to determine gross profit. The video discusses how different inventory costing methods, such as FIFO and LIFO, affect the calculation of COGS.

💡Ending Inventory

Ending inventory is the value of the inventory remaining on hand at the end of an accounting period. It is calculated after the cost of goods sold has been determined. The video emphasizes that the allocation of costs to ending inventory is part of the inventory costing process and impacts the balance sheet.

💡Gross Profit

Gross profit is the profit a company makes after deducting the costs associated with producing the goods sold, but before deducting other operational costs. It is calculated as sales minus cost of goods sold. The video script explains how the allocation of costs between cost of goods sold and ending inventory affects gross profit.

💡Inventory Valuation

Inventory valuation is the process of determining the value of a company's inventory. It is an important aspect of financial reporting and can be done using various methods like FIFO, LIFO, or weighted average. The video discusses the different inventory valuation methods and their implications for financial statements.

💡Cost Flow Assumption

Cost flow assumption refers to the hypothetical path that inventory costs take as they move from purchase to sale in the accounting records. This assumption does not necessarily reflect the physical flow of goods. The video highlights that the chosen costing method, like FIFO or LIFO, is based on these assumptions and can affect the financial statements.

💡Balance Sheet Equality

Balance sheet equality refers to the balance between assets and liabilities plus owner's equity, which must always be maintained. The video script mentions that changes in inventory valuation affect other parts of the balance sheet, such as retained earnings, to maintain this equality.

Highlights

Introduction to inventory costing concepts.

Explanation of FIFO, LIFO, and weighted average methods.

Importance of allocating costs between cost of goods sold and ending inventory.

Impact of cost allocation on gross profit and balance sheet.

Principles of including costs in ending inventory.

Exclusion of carrying costs and selling costs from inventory valuation.

Necessity of adopting a consistent inventory costing method.

Cost flow assumptions and their irrelevance to physical flow of goods.

FIFO method explanation and example.

LIFO method explanation and example.

LIFO's unique status as a U.S. accounting method.

Weighted average method explanation and example.

Encouragement to understand the mathematics behind FIFO, LIFO, and weighted average.

Summary of cost allocation between ending inventory and cost of goods sold.

Emphasis on the independence of costing methods from physical flow of goods.

Visual representation of FIFO, LIFO, and weighted average methods.

Anticipation of the next module with mathematical examples.

Transcripts

This is principlesofaccounting.com, Chapter 8, on Inventory.

In this particular module, we will look at the basic concepts of inventory costing.

FIFO, LIFO, weighted average methods.

This is a very important module.

Now let's start with the basics however.

The aggregation of the beginning inventory and

purchases gives us the goods available for sale.

Our challenge is then to take that total amount assigned to good available for

sale and decide how much is included in ending inventory for the balance sheet.

And how much should be reported as cost of goods sold on the income statement.

It's really an allocation problem.

The cost of goods available for

sale must be allocated either to cost of goods sold or to ending inventory.

Cost of goods sold appearing on the income statement sales minus cost of goods sold

getting you gross profit or ending inventory appearing on the balance sheet.

Before we look at the specific methods like FIFO and LIFO though, consider this.

If I allocate $1 more to cost of goods sold, through my costing methods, and

one dollar less to ending inventory, that's a necessary thing that occurs.

If what's available to allocate, if I place one dollar more here,

I necessarily place one dollar less there.

And by placing one dollar more in cost of goods sold,

that causes gross profit to be less.

Sales minus an increased cost of goods sold and giving less gross profit and

$1 less than the inventory would give me less on the balance sheet for

the asset inventory.

So, inventory's pushed down, profits are pushed down,

retained earnings is pushed down, balance sheet equality is maintained because.

Inventory's going down as are profits

if I were to shift that $1 from one category to the other.

Now, as we think about what costs to include in ending inventory,

it's important to remember that inventory should include all costs that are ordinary

and necessary to put the goods in place and in condition for resale.

This would include the invoice price, the freight cost.

That is freight in the cost that is necessary to bring it to its intended

condition for resale and similar items.

It does not include however carrying cost of inventory such as interest

that's incurred on financing inventory, storage, or insurance cost.

Those costs are expenses incurred.

They are not inventoriable type costs.

Also excluded are selling costs, freight outcost,

which is deemed to be a selling cost, salesman commissions and so on.

Those costs are also expensed as incurred.

Now, Costing Methods.

Each unit of inventory will not always have the same cost, as we buy or

acquire manufactured goods, there may be a different cost that's incurred per unit.

Therefor a company must adopt an inventory costing method

that is applied consistently from year to year to

allocate the cost of all of the units to the units that are in ending inventory and

the units that are actually sold, or cost of goods sold.

So this gives rise to certain cost flow assumption which are assumptions

of how costs are assigned to inventory.

It bears no relation to physical flow of goods.

If we're talking about milk, for example,

we could cost that milk inventory by FIFO or LIFO or an average cost method.

Even though selling that milk, we would probably try to sell it on a first in,

first out basis to get rid of the older stock and constantly keep the newer stock.

Hold it back until we clear the older stock out of the inventory.

But no matter how our physical flow is occurring such as I described for milk, we

could use any of these methods to assign the cost flow for accounting purposes.

Looking at First-In, First-Out or FIFO, the oldest cost,

the first in are matched against revenue and assigned to cost of goods sold first.

The recent purchases, those that are left over,

the most recent cost, is assigned to ending inventory.

Looking at an example, we had 0 beginning inventory.

These are nails, barrels of nails.

And we had three purchases during the period.

We bought 100 lbs of nails at $1, 100 lbs at $1.10, and 100 lbs at $1.20.

The total cost of all of our purchases was $330.

Our goods available for sale was $330.

When we allocated this on a first in first out basis,

we sold 160 pounds of this particular case.

What sold first was this red barrel at $1.

60 pounds out of the green barrel at $1.10.

That's our 160 lbs that were sold from the first units purchase,

the red and the green.

And we came up with costs of goods sold of 166.

The other amounts, the 40 lbs that remains from the green barrel and

the 100 lbs in the blue barrel even though the units are all commingled,

those amounts were signed in the inventory.

Conversely, Last-In, First-Out is just the opposite.

The recent costs are matched against revenue and

assigned to cost of goods sold, while the oldest purchases remain in inventory.

So here, we have the same purchases of barrels of nails,

three barrels at 100 lbs each at a different cost per lb.

When we assign our $330 of cost of goods available for

sale here we're taking the blue and the green first, that is the last in

is the first out and we're assigning that to cost of goods sold, its $186.

The ending inventory is from the earliest purchases during the period.

Last in, first out.

Last in, first out is uniquely a United States based accounting method.

Many parts of the world will not recognize or allow the LIFO method.

Finally, the weighted-average method is a blending of these two approaches.

An average unit cost is used to calculate the cost of goods sold and

ending inventory.

It's very simply determined by dividing total cost of goods available for

sale by total units.

So on our nail example, $330 was spent on 300 pounds of nails,

giving us an average cost of $1.10 per pound.

And with 176 pounds sold at $1.10, we had $176 in cost of goods sold.

And our ending inventory 140 pounds times the same $1.10 average cost

gave us $154 assigned to ending Inventory.

You might find it helpful, indeed I would encourage you to look at the textbook,

this very illustration is used in the textbook, and explained in there again.

And it probably would be helpful to actually sit down and really think about

the mathematics of what's happening with FIFO, LIFO and weighted average.

To recap, first, remember that beginning inventory and

purchases gives us cost of goods available for sale and that

amount of cost must be allocated either to ending inventory or cost of goods sold.

Second, accountants adopt a cost flow assumption to track those inventory costs

within the accounting system, whether that's FIFO, WIPO or average cost.

Third, the adopted cost flow assumption need not bear

any relation to the actual physical flow of goods.

The costing method is independent of the physical flow of goods.

To recap briefly then, with first in first out,

we have our beginning inventory in gold and our purchases in blue here.

Together that comprises our goods available for sale.

Under first in, first out, our cost of good sold includes those gold

units from beginning inventory, as well as some of the purchases.

What's an ending inventory?

It was from the very last purchases during the period.

LIFO is just the opposite.

Here we have the same beginning inventory and

purchases rolled together to give us goods available for sale.

The ending inventory is all gold.

It came from the beginning inventory in this case and

indeed a little bit of the beginning inventory is deemed to be liquidated along

with all the purchases in the period.

And the weighted average, what I try to show here is all of the cost gets blended

together for an average cost and that cost is then dispersed in both ending inventory

as well as our cost of goods sold.

In the next module, we will look at actual mathematical examples of applying FIFO,

LIFO, and average methods.