BU.210.620 Chap.5 Inventory Costing and Cost of Goods Sold
Inventory Costing and Cost of Goods Sold
What inventory cost includes
Module 5 applies the cost principle to goods held for sale. Inventory cost is the invoice price plus the costs of getting goods to a saleable condition and location, such as freight-in, inspection and preparation, less purchase returns, allowances and discounts. Selling costs are period expenses, not inventory.
Merchandisers carry one inventory account; manufacturers carry raw materials, work in process and finished goods, with direct labour and factory overhead added in production.
Product costs become cost of goods sold only when the goods are sold, and beginning inventory plus purchases minus ending inventory always equals cost of goods sold.
Perpetual and periodic systems
A perpetual system updates inventory with every purchase and sale, so each sale is recorded twice, at selling price and at cost.
A periodic system counts inventory at period end and derives cost of goods sold from the equation, with units sold found by subtracting the count from units available. Either way, when identical units were bought at different prices, the company must choose a cost flow assumption.
Four methods and their effects
Specific identification tracks individual units.
FIFO assigns the oldest purchase prices to cost of goods sold, leaving recent prices in ending inventory; LIFO does the reverse; weighted average applies one average cost to both. The assumptions describe prices, not the physical flow of goods. When costs rise, FIFO reports lower cost of goods sold, higher income and higher taxes, while LIFO reports the opposite; when costs fall, the effects reverse.
FIFO ending inventory is always closest to current cost.
Choosing a method
The LIFO conformity rule ties US tax and book reporting together, methods must be applied consistently, and a LIFO company that sells down old layers can see profits and taxes jump. When prices are falling, FIFO usually gives the lowest tax and is used for both tax and reporting.
Inventory efficiency itself is measured in the analysis chapter with inventory turnover and days to sell.
What this chapter covers
- 01
Inventory goals and inventory types
- 02
Cost principle and capitalised costs
- 03
Cost of goods sold equation
- 04
FIFO, LIFO, weighted average and specific identification
- 05
Rising versus falling costs and the LIFO conformity rule
Worked example · free
Weighted average cost under a periodic system
- 2Goods available: 40 × 30 + 60 × 35 = $3,300 for 100 lamps, an average of $33.
- 2Units sold: 100 available minus 25 counted = 75; cost of goods sold 75 × 33 = $2,475.
- 2Ending inventory 25 × 33 = $825; check 2,475 + 825 = $3,300.
Key terms
- Freight-in
- Freight-in is the transport cost of bringing purchased goods to the buyer, and it is added to the cost of inventory.
- Goods available for sale
- The pool of cost a period can expense: beginning inventory plus purchases, later divided between cost of goods sold and ending inventory.
- LIFO liquidation
- A LIFO liquidation occurs when a LIFO company sells more units than it buys, pushing older, lower costs into cost of goods sold.
- Perpetual inventory system
- A perpetual inventory system updates the inventory account with every purchase and sale, so cost of goods sold is recorded at the moment of each sale.
- Weighted average cost
- Weighted average cost is the cost of goods available for sale divided by the units available, applied to both the units sold and the units still on hand.
Inventory Costing and Cost of Goods Sold FAQ
Does FIFO mean the oldest units physically leave first?
Not necessarily. Cost flow methods are assumptions about which purchase prices are matched against revenue; the warehouse can ship goods in any order and the company may still report under FIFO, LIFO or average cost.
Why would a company prefer LIFO when prices are rising?
Higher recent costs flow into cost of goods sold, lowering taxable income and taxes. Under the conformity rule it must then report the lower LIFO income to shareholders as well.
Which purchase costs are added to inventory?
The invoice price plus costs of getting the goods ready for sale, such as freight-in, inspection and preparation, less purchase returns, allowances and discounts. Advertising, sales commissions and delivery to customers are selling expenses instead.
Exam move
Set up one units table, available, sold and on hand, then price it three ways in parallel columns. Finish by writing the rising-cost and falling-cost effects on income and taxes from memory.
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