The computation of an inventory item's cost is the starting point for inventory valuation and figuring the cost of goods sold. The recorded cost of inventory incorporates all expenditures related to acquisition such as the purchase price of the merchandise, less any purchase discounts, transportation charges incurred by the purchaser, and insurance costs incurred on the merchandise while in transit.
Once the preceding expenditures are determined, the unit cost of each inventory item can be calculated. The purchase price of inventory is easily associated with specific items, but it is frequently difficult to compute unit amounts for transportation, insurance, and discounts. This is because transportation and insurance are often incurred on shipments that consist of a variety of inventory items. Similarly, the purchase discount on a single invoice may relate to numerous products. As a result, these elements should be handled as follows.
In an ideal situation, where discounts, transportation, and insurance are traceable to a particular inventory item, the cost of that item is computed accordingly. For example, suppose Taylor Corporation had the following costs for Item No. 2000:
Exhibit 9-5
|
Purchase Price |
500 Units @ $10 |
$5,000 |
|
Add |
Transportation Charges |
$ 350 |
|
Less |
Purchase Discounts |
$ 100 |
|
Total Adj. Cost |
$5,250 |
|
Cost Per Unit |
$5,250 ÷ 500 |
$10.50 |
It is assumed that:
1. these costs relate strictly to Item No. 2000, and
2. there is no beginning inventory.
If 100 units remain on-hand at the end of the year, Taylor's inventory pool would be divided as shown in Exhibit 9-5 above.
If discounts, transportation, and other acquisition costs are significant in amount and cannot be traced to specific inventory items, some form of equitable prorating is necessary between the total ending inventory and the cost of goods sold. The lack of such prorating could result in a serious misstatement on both the balance sheet and the income statement. In many cases, discounts and transportation charges are small in relation to an item's purchase price. Therefore, as a matter of expediency, no prorating is attempted, and the purchase discounts and freight-in accounts are entered in their entirety on the income statement.
Below are the generally accepted reporting systems and costing methods that a company may use.
1. The Specific Identification method requires a company to physically identify each unit of merchandise with a tag or sticker, when possible, with the unit cost of that item, which is maintained until that item has sold.
To illustrate the specific identification method, we will examine the following data of Taylor Corporation for Item No. 1050.
|
|
Number Of Units |
Cost Per Unit |
Total Cost |
|
Beginning Inventory |
3000 |
$3.00 |
$9,000 |
|
Purchase 2/28 |
4000 |
$3.10 |
$12,400 |
|
Purchase 5/15 |
5000 |
$3.23 |
$16,150 |
|
Purchase 8/01 |
1000 |
$3.50 |
$3,500 |
|
Purchase 10/31 |
3000 |
$3.60 |
$10,800 |
|
Goods Available For Sale |
16000 |
|
$51,850 |
During the year Taylor Corporation sold 11,800 units, leaving 4,200 units [16,000 - 11,800], in inventory.
While determining the cost of goods sold, and the ending inventory valuation, the firm's accountant found that the units sold and units on-hand consisted of the following:
|
|
Cost Per Unit |
Total Units |
Units Sold |
Units On-Hand |
|
Beginning Inventory |
$3.00 |
3000 |
3000 |
- |
|
Purchase 2/28 |
$3.10 |
4000 |
3000 |
1000 |
|
Purchase 5/15 |
$3.23 |
5000 |
5000 |
- |
|
Purchase 8/01 |
$3.50 |
1000 |
800 |
200 |
|
Purchase 10/31 |
$3.60 |
3000 |
- |
3000 |
|
Total Units |
16000 |
11800 |
4200 |
Therefore, the cost of the ending inventory is calculated as follows:
|
|
Number Of Units |
Cost Per Unit |
Total Cost |
|
Purchase 2/28 |
1,000 |
$3.10 |
$ 3,100 |
|
Purchase 8/01 |
200 |
$3.50 |
$ 700 |
|
Purchase 10/31 |
3,000 |
$3.60 |
$10,800 |
|
Ending Inventory |
4,200 |
|
$14,600 |
There are two ways to compute the cost of goods sold. First, the cost of each batch that sold during the year can be evaluated. Therefore, the cost of the ending inventory is calculated as follows:
|
|
Total Units |
Cost Per Unit |
Total Cost |
|
Beginning Inventory |
3000 |
$3.00 |
$ 9,000 |
|
Purchase 2/28 |
3000 |
$3.10 |
$ 9,300 |
|
Purchase 5/15 |
5000 |
$3.23 |
$16,150 |
|
Purchase 8/01 |
800 |
$3.50 |
$ 2,800 |
|
Cost Of Goods Sold |
11800 |
|
$37,250 |
Alternatively, because goods available for sale, minus the ending inventory, equal cost of goods sold, the following can be done.
|
Goods Available for Sale (see page 12) |
$51,850
|
|
Less: Ending Inventory |
$14,600 |
|
Cost Of Goods Sold |
$37,250 |
This method matches the actual cost of units sold against sales revenues. Additionally, it allows management to manipulate net income by selectively selling their goods with high or low costs, therein producing different levels of profit. Overall, the specific identification method is seldom used, as most companies find that the cost of record keeping outweighs the projected benefits from its use.
Furthermore, the physical tagging or coding of individual units of merchandise is impractical, if not impossible, in many situations. Imagine the difficulty a grocery store would experience given the store's sales volume, the size and composition of its inventory, as well as the susceptibility to supplier price changes. This method is most feasible when the volume of sales is low, and the cost of individual units is high.
When the specific identification method is not employed, the auditor must make an assumption regarding the flow of costs through a firm's accounting system, which will have a bearing on the appraiser’s ultimate findings. That is, should the cost of goods sold be computed by using the oldest costs that the firm has experienced, the most recent costs, or perhaps an average cost? If the cost of goods sold is computed at the oldest costs, the most recent costs are then used for the valuation of the ending inventory. This practice is consistent with splitting the goods available for sale, e.g., old costs and recent costs combined between the income statement and the balance sheet. Recognizing that a cost flow assumption pertains strictly to the flow of cost through the accounts, and has no direct relationship to the actual flow of goods. In most cases, a business will attempt to sell the oldest merchandise first because of a threat of some form of depreciation. It is very possible that this business will cost these goods at the most recent costs experienced. Again, there is no direct connection between the physical flow of goods, and the cost flow assumption used in the goods accounting. The selection of a cost flow assumption is dependent on other factors.
There are three widely used Cost Flow Assumptions: First-in, First-out (FIFO); Last-in, First-out (LIFO); and Weighted-Average. These assumptions will be illustrated by using the data from Taylor Corporation.
1. The Last-in, First-out (LIFO) method carries the stated unit cost at the cost of the most recent purchase. This is based on the assumption that the most current unit will be the first to sell. However, this assumption does not follow the actual flow of goods. Therefore, the ending inventory comprises a unit cost of the most dated purchase thus; the cost of Taylor Corporation’s 4,200-unit ending inventory would be computed as follows:
|
|
Number Of Units |
Cost Per Unit |
Total Cost |
|
Beginning Inventory |
3000 |
$3.00 |
$ 9,000 |
|
2/28 Oldest Purchase |
1200 |
$3.10 |
$ 3,720 |
|
Ending Inventory |
4200 |
|
$12,720 |
Though Taylor Corporation purchased 4,000 units on February 28, the cost of only 1,200 of these units is needed for inclusion in the ending inventory.
The cost of goods Sold is $39,130:
|
Goods Available for Sale |
$51,850 |
|
Less: Ending Inventory |
$12,720 |
|
Cost Of Goods Sold |
$39,130 |
2. The First-in, First-out (FIFO) method is based on the assumption that the first goods purchased are the first goods sold, which would maintain a more current inventory due to depreciation factors. Therefore, the ending inventory would comprise the most recent purchases, which would be advantageous to a company using its inventory as collateral for financial considerations.
This method conforms to reality for many companies, because they generally desire to sell older inventories first. However, the FIFO cost flow may be used for any physical flow of goods. Under FIFO, since the oldest goods are assumed to be disposed of first, the ending inventory is composed of the most recent purchases. Therefore, Taylor Corporation’s 4,200-unit ending inventory would consist of the following:
|
|
Number Of Units |
Cost Per Unit |
Total Cost |
|
10/31 Most Recent Purchase |
3,000 |
$3.60 |
$10,800 |
|
8/01 Next Most Recent Purchase |
1,000 |
$3.50 |
$ 3,500 |
|
5/15 Next Most Recent Purchase |
200 |
$3.23 |
$ 646 |
|
Ending Inventory |
4,200 |
|
$14,946 |
Observe that only 200 units from the May 15 purchase are needed to complete the accounting for the ending inventory; the other 4,800 units [5,000 - 200], are no longer on-hand.
The cost of the 11,800 units sold can be computed as follows:
|
|
Number Of Units |
Cost Per Unit |
Total Cost |
|
Beginning Inventory |
3000 |
$3.00 |
$ 9,000 |
|
2/28 Oldest Purchase |
4000 |
$3.10 |
$12,400 |
|
5/15 Next Oldest Purchase |
4800 |
$3.23 |
$15,504 |
|
Cost Of Goods Sold |
11800 |
|
$36,904 |
Alternatively, the cost can be computed as follows:
|
Cost Available for Sale |
$51,850 |
|
Less: Ending Inventory |
$14,946 |
|
Cost Of Goods Sold |
$36,904 |
3. The Weighted-Average method is, in effect, the use of average cost, which is a compromise between LIFO and FIFO. Taking an average of all costs calculates average cost for a particular item and, as a result, recognizes cost swings. This method is based on the premise that all goods available for sale, within the same SKU, at a particular period, should reflect the same unit cost. Therefore, rather than focus on the time when costs are incurred, i.e., currently or in the past, this method computes an average cost by weighting (multiplying the Cost of Goods Available for Sale ÷ Units Available for Sale):
[$51,850 ÷ 16,000] = $3.24
The unit cost of $3.24 is applied to the ending inventory as follows:
[4,200 Units X $3.24] = $13,608
Cost of Goods Sold is computed in the same manner as before, which is:
|
Goods Available For Sale |
$51,850 |
|
Less: Ending Inventory |
$13,608 |
|
Cost Of Goods Sold |
$38,242 |
