Week 7 · Chapter

Chapter 7 — Inventory Costing

Financial Accounting Free sample edition

The module's primary reading · ~40–50 minutes · Objective 5 (account for merchandising operations and inventory: record purchases and sales in a perpetual system, compute cost of goods sold and gross profit, and apply FIFO, LIFO, and weighted-average costing and the lower of cost and net realizable value), with Objective 1 (explain the purpose of financial accounting, its users, the forms of business organization, the roles of GAAP, the FASB, the SEC, and IFRS, and the ethical principles that guide accountants) and Objective 4 (complete the accounting cycle: prepare an income statement, a statement of retained earnings, and a classified balance sheet, journalize closing entries, and prepare a post-closing trial balance) called back · Read it first this week; the lecture, the tutorial, the quiz, and the Accounting Workshop all build on it.

In plain language

A store often buys the same item several times at different prices. When it sells some of them, it has to decide which price to count as the cost of what it sold. That decision is called a cost flow assumption (a rule for which costs count as sold and which stay on the shelf). This week you learn the four common rules and work each one on the same set of bicycle helmets. You also learn two rules set by outside bodies: one framework does not allow one of the methods, and inventory can never be reported above what it is expected to bring in.

Why you already care about this

Picture the helmet shelf at the bicycle shop (illustrative). The shop started the period with 20 helmets that cost $30 each. It bought 40 more at $33, and later 40 more at $36. Then it sold 70 helmets at $50 each. The helmets all look the same, and nobody wrote a price on the inside of each one.

So what did the 70 helmets that were sold cost? If they were the cheap ones, the shop's profit looks bigger. If they were the expensive ones, it looks smaller. The shop paid the same total either way. Only the split changes. That split decides how much profit the income statement reports and how much cost sits in Inventory on the balance sheet.

You meet this choice anywhere prices move: a hardware store whose paint costs rise through the year, a coffee roaster whose bean prices swing with each harvest, a clinic restocking gloves. Every one of them has to pick a rule.

By the end of this chapter you will be able to:

compute the cost of goods available for sale from beginning inventory and purchases;
explain why a cost flow assumption need not match the order in which goods leave;
compute cost of goods sold, ending inventory, and gross profit by FIFO, LIFO, and weighted average;
describe each method's effects when costs rise, without ranking the methods;
apply the lower of cost and net realizable value and compute a write-down;
explain how an inventory error moves net income across two years.

Carry this line with you: the method moves costs — not helmets.

Where we are

Already covered: Week 6 added the business that buys and resells goods, with Inventory, Cost of Goods Sold, gross profit, and the perpetual and periodic systems. Week 5 built the classified balance sheet, whose current assets are items a business expects to turn into cash or use up within one year or the operating cycle; Inventory is one of them.
This week: the cost of goods available for sale, the four cost flow assumptions, their effects when costs rise, consistency, the IFRS rule on LIFO, the lower of cost and net realizable value, and inventory errors.
How they connect: last week every bicycle cost the same $410, so cost of goods sold was one multiplication; this week the same item has three costs, and you need a rule to split them.
Where we're going next: Week 8, Midterm Review & Exam, reviews Weeks 1 to 7 and adds internal control, including the controls that protect inventory.

Week 6 is the one this chapter leans on most. Recall that cost of goods sold is the cost of the goods sold during the period, not the cost of everything bought. Recall too that gross profit is sales revenue minus cost of goods sold. In a periodic inventory system, a business finds cost of goods sold at the end of the period from a count of what is left. This week's helmets use a periodic system. Week 1 matters too: it told you that U.S. GAAP and IFRS are two sets of standards, compared without ranking. This week you meet one place where they differ.

1. Add up what the shop could sell: the cost of goods available for sale

Think of a jar of coins you fill all month. At the end of the month, the jar holds what you started with plus what you added. Inventory works the same way.

The cost of goods available for sale is the total cost of all the goods a business could have sold in a period: the cost of its beginning inventory plus the cost of its purchases.

The helmets came in three groups, each bought at its own price. Each group is an inventory layer: a group of identical units a business bought at one unit cost, kept apart so its cost can be traced.

Worked example — the helmet layers. You multiply each layer's units by its unit cost, then add the layers.

The bicycle shop's three helmet layers, in units and dollars (Dataset D, illustrative)
Layer	Units	Unit cost	Cost
Beginning inventory	20	$30	$600
Purchase 1	40	$33	$1,320
Purchase 2	40	$36	$1,440
Available	100		$3,360

The units add to 20 + 40 + 40 = 100 helmets. The costs add to 600 + 1,320 + 1,440 = $3,360. The shop sold 70 helmets at $50 each, so sales were 70 × $50 = $3,500. That leaves 100 − 70 = 30 helmets on the shelf.

In words: the shop had $3,360 of helmets it could sell, and every method you meet this week splits that same $3,360 into two parts. One part, cost of goods sold, goes to the income statement for the 70 helmets sold. The other part, ending inventory, stays on the balance sheet for the 30 helmets left.

The helmets also give you a check you can use every time:

cost of goods sold + ending inventory = cost of goods available for sale

Misconception check. Students often think cost of goods sold is the cost of everything the shop bought, $2,760 of purchases here (1,320 + 1,440). It is not. Cost of goods sold covers only the goods that were sold, and it can include beginning inventory. The cure: start from the cost of goods available for sale, then take out what is still on the shelf.

2. Choose a rule for the costs: the cost flow assumption

At a grocery co-op, the bulk rice bin is refilled from the top. New rice lands on old rice, and the scoop takes whatever is on top. Nobody can tell one grain's price from another. Yet the co-op still has to say what the rice it sold cost.

A cost flow assumption is a rule for deciding which unit costs move to cost of goods sold and which stay in ending inventory. It need not match the order in which the goods physically leave.

That last sentence is the heart of your week. A cost flow assumption is an accounting convention, a choice U.S. GAAP allows, and not a description of the shelf. The co-op could scoop rice from the top and still count its oldest costs as sold first.

U.S. GAAP allows several assumptions. This chapter covers four:

specific identification, which tracks each unit's actual cost (Section 3);
first-in, first-out, or FIFO (Section 4);
last-in, first-out, or LIFO (Section 5);
weighted average (Section 6).

Misconception check. Students often think FIFO and LIFO describe which goods physically leave first, so a shop that sells its oldest helmets first "must" use FIFO. That is not the rule. They describe which costs are counted as sold. The cure: when you hear FIFO or LIFO, think "costs", never "boxes".

3. Track each unit: specific identification

Some goods are easy to tell apart. A used guitar has a serial number. A hand-built bicycle frame has one too. When each item is unique and costly, a business can track what each one cost.

Specific identification is a costing method that tracks the actual cost of each unit sold, used for goods that are few, costly, and easy to tell apart.

Worked example — a used-instrument shop (fresh case). A small shop that sells used instruments owns three guitars. One cost $400, one cost $650, and one cost $900. It sells the $650 guitar for $1,000. Under specific identification, cost of goods sold is $650, the actual cost of the guitar that left. Gross profit is 1,000 − 650 = $350. Ending inventory is the two guitars still on the wall: 400 + 900 = $1,300. In words: the shop knows exactly which guitar it sold, so it counts exactly that guitar's cost.

The helmets are different. They are identical, cheap, and many. Writing a cost inside each helmet would take more effort than the information is worth. That is why the bicycle shop uses one of the other three assumptions.

Misconception check. Students often think specific identification is the "honest" method and the others are guesses. Each method follows a stated rule that U.S. GAAP allows. The cure: match the method to the goods, and describe its effects, not its virtue.

4. Send the oldest costs out first: FIFO

Think of a carton of eggs at home. You use the ones you bought first, before they go bad. The first in is the first out.

First-in, first-out (FIFO) is a cost flow assumption under which the oldest unit costs are counted as sold first, so ending inventory carries the newest costs.

Worked example — the helmets by FIFO. The shop sold 70 helmets. You count the oldest costs first.

Take all 20 beginning helmets at $30: 20 × $30 = $600. That is 20 helmets; 50 more to go.
Take all 40 helmets from Purchase 1 at $33: 40 × $33 = $1,320. That is 60 helmets; 10 more to go.
Take 10 helmets from Purchase 2 at $36: 10 × $36 = $360. That is all 70.

Cost of goods sold is 20 × $30 + 40 × $33 + 10 × $36 = 600 + 1,320 + 360 = $2,280.

Ending inventory is the 30 helmets left from Purchase 2: 30 × $36 = $1,080. Check it: 2,280 + 1,080 = $3,360, the cost of goods available for sale.

Gross profit is 3,500 − 2,280 = $1,220.

In words: under FIFO the shop counts its oldest, cheapest helmets as sold, so the 30 helmets left on the shelf carry the newest cost of $36 each.

In practice (your tools). In a free spreadsheet, put each layer on its own row, with units in column B and unit cost in column C, and compute each layer's cost with a formula such as =B2*C2. Find the FIFO cost of goods sold with =20*30+40*33+10*36, or better, with cell references to the layers. Then compute ending inventory as cost of goods available for sale minus cost of goods sold, and add the two back together in a check cell. If the check cell does not show 3,360, a layer was counted twice or left out.

Misconception check. Students often think FIFO's ending inventory is a mix of all three layers. Under FIFO the oldest costs leave first, so ending inventory holds the newest layer's cost. The cure: name the layer each remaining unit comes from before you multiply.

5. Send the newest costs out first: LIFO

Picture a stack of plates in a cafeteria. Clean plates go on top, and diners take from the top. The last one in is the first one out.

Last-in, first-out (LIFO) is a cost flow assumption under which the newest unit costs are counted as sold first, so ending inventory carries the oldest costs.

Worked example — the helmets by LIFO. This time you count the newest costs first.

Take all 40 helmets from Purchase 2 at $36: 40 × $36 = $1,440. That is 40 helmets; 30 more to go.
Take 30 helmets from Purchase 1 at $33: 30 × $33 = $990. That is all 70.

Cost of goods sold is 40 × $36 + 30 × $33 = 1,440 + 990 = $2,430.

Ending inventory is what is left: all 20 beginning helmets and 10 from Purchase 1. That is 20 × $30 + 10 × $33 = 600 + 330 = $930. Check it: 2,430 + 930 = $3,360.

Gross profit is 3,500 − 2,430 = $1,070.

In words: under LIFO the shop counts its newest, costliest helmets as sold, so its cost of goods sold is closer to what helmets cost now, and the helmets left carry the oldest costs.

Misconception check. Students often think LIFO gives lower cost of goods sold when costs are rising. It gives higher. When each purchase costs more than the last, the newest costs are the biggest, and LIFO sends them to cost of goods sold first. The cure: when costs rise, LIFO's cost of goods sold is the larger figure, $2,430 against FIFO's $2,280 here.

6. Spread one cost over every unit: weighted average

Imagine pouring three jugs of juice, bought at three prices, into one pitcher. Every glass you pour now has the same blended cost. That is the idea of an average.

Weighted average is a cost flow assumption that gives every unit the same average cost, found by dividing the cost of goods available for sale by the units available.

Worked example — the helmets by weighted average. You work it in five steps.

Find the average unit cost: 3,360 ÷ 100 = $33.60 a helmet.
Apply it to the helmets sold: 70 × $33.60 = $2,352 of cost of goods sold.
Apply it to the helmets left: 30 × $33.60 = $1,008 of ending inventory.
Check it: 2,352 + 1,008 = $3,360.
Gross profit is 3,500 − 2,352 = $1,148.

In words: under weighted average every helmet carries the same $33.60 cost, so cost of goods sold and ending inventory both land between the FIFO and LIFO figures.

The word "weighted" matters. The average is not (30 + 33 + 36) ÷ 3, which treats a 20-helmet layer as if it were as big as a 40-helmet layer. It is the total cost divided by the total units, so each layer counts by its size.

Misconception check. Students often think the average cost is the average of the three unit prices. That ignores how many helmets each price bought. The cure: divide total cost by total units, $3,360 ÷ 100 here, every time.

7. Compare the methods by their effects

Here are the three methods side by side, so you can compare them. Each row splits the same $3,360, and each starts from the same $3,500 of sales.

Cost of goods sold, ending inventory, and gross profit for 70 helmets sold and 30 left, by method, in dollars (Dataset D, illustrative)
Method	Cost of goods sold	Ending inventory	Gross profit
FIFO	$2,280	$1,080	$1,220
LIFO	$2,430	$930	$1,070
Weighted average	$2,352	$1,008	$1,148

Read the table one column at a time, and you will see a pattern. When costs are rising, as they did for the helmets:

FIFO gives the lowest cost of goods sold and the highest ending inventory and gross profit.
LIFO gives cost of goods sold closer to current costs.
Weighted average falls between the two.

The gap is easy for you to see. LIFO cost of goods sold minus FIFO cost of goods sold is 2,430 − 2,280 = $150. FIFO gross profit minus LIFO gross profit is 1,220 − 1,070 = $150, the same gap.

Say it in one plain sentence: under LIFO the shop reports $150 more cost of goods sold than under FIFO, because the newest, costliest helmets are counted as sold first.

Notice what your sentence does not say. It does not say which method is better. Each one is an allowed choice under U.S. GAAP, and each one tells a reader something different. FIFO's balance sheet figure sits closer to recent costs. LIFO's income statement figure sits closer to recent costs. That is a trade, and this course describes it rather than judging it.

Now try the same reasoning on two fresh businesses, in words only. A hardware store's paint cost more with every order this year, so its pattern matches the helmets: FIFO would give it the lower cost of goods sold. A coffee roaster's green beans got cheaper with every order. Turn the reasoning around: now the oldest beans carry the highest costs, so FIFO sends the highest costs to cost of goods sold first.

Whatever method a business picks, it keeps it, and you will see it named in the notes to the statements. Consistency is the practice of applying the same accounting method from period to period so a business's statements can be compared, with the method disclosed to readers. A reader comparing this year's gross profit with last year's needs to know the same rule produced both.

Pause and choose one of these to think through, whichever you prefer:

(a) You run the hardware store and its paint costs keep rising. Describe in one or two sentences what a lender reading your income statement would see under FIFO, and what it would see under LIFO.
(b) A friend says, "I'll switch to whichever method makes this year look best." Explain to your friend, in your own words, why consistency stands in the way.

Misconception check. Students often think a business can switch methods whenever it likes, at no cost. A change breaks comparability: this year's figures and last year's would come from different rules, and a reader could mistake the switch for a change in the business. The cure: treat the method as a standing choice, applied every period and disclosed.

8. Follow two rules from their sources: LIFO and IFRS, and the lower of cost and net realizable value

Two rules you meet this week come from outside bodies, and you state each one the way its source states it.

LIFO and IFRS. IFRS does not allow LIFO, as the SEC stated in 2008 in Release No. 33-8982; U.S. GAAP permits it. That is a documented rule, not a debate. Week 1 compared the two frameworks without ranking them, and this is one plain difference between them. A business reporting under IFRS chooses among the other methods.

The lower of cost and net realizable value. Suppose a newer helmet model arrives and shoppers no longer want the old one at full price. The 30 helmets on the shelf may now bring in less than they cost. You would not want a balance sheet to report them above what they are expected to bring in.

Net realizable value is the amount a business expects to receive for its goods, less the costs to finish and sell them.

The lower of cost and net realizable value is the rule that inventory measured by FIFO or average cost is reported at its cost or its net realizable value, whichever is lower, under the FASB's Accounting Standards Update No. 2015-11. Inventory measured by LIFO or by the retail inventory method stays under the earlier lower-of-cost-or-market guidance; you only need its name this week.

Worked example — the helmet write-down. The shop expects to receive $34 a helmet, net of selling costs.

Net realizable value of the 30 helmets: 30 × $34 = $1,020.
FIFO cost of the 30 helmets: $1,080, from Section 4.
Compare: $1,080 is higher than $1,020, so cost is not the lower amount.
The write-down is 1,080 − 1,020 = $60, and FIFO ending inventory is reported at $1,020.

A write-down is a reduction of an asset's reported amount to a lower measure, such as inventory reduced from its cost to its net realizable value, with the reduction reported as an expense of the period. Here Inventory falls by $60 and the period's expenses rise by $60.

Under weighted average the test comes out the other way. Cost is $1,008, which is lower than the $1,020 net realizable value, so no write-down is needed.

Here is an honesty note about these figures. The $34 is a given in this example. In a real business, net realizable value is an estimate, and the people who make it can disagree. The rule tells you how to compare; it does not make the estimate for you, and you should say so when you report it.

Misconception check. Students often think LIFO is allowed everywhere because U.S. GAAP allows it. IFRS does not allow LIFO. The cure: whenever you see LIFO, ask which framework the statements follow before you accept it.

9. Trace an inventory error across two years

Picture two dominoes you have set up in a row. Knock the first, and the second moves too. An inventory count works the same way, because this year's ending inventory becomes next year's beginning inventory.

An inventory error is a mistake in the amount of ending inventory. It misstates cost of goods sold and net income in that year and the opposite way in the next year, because one year's ending inventory is the next year's beginning inventory.

You can walk it in words. Suppose a count at the end of Year 1 includes boxes that were already sold, so ending inventory is overstated.

Year 1. Cost of goods sold is the cost of goods available for sale minus ending inventory. Too much ending inventory means too little cost of goods sold, so cost of goods sold is understated and net income is overstated.
Year 2. The overstated ending inventory carries in as Year 2's beginning inventory. Too much beginning inventory means too much cost of goods available for sale, so cost of goods sold is overstated and net income is understated.
Across both years. The two errors offset, so the two-year total of net income comes out right. Each year's statements are still wrong, and a reader comparing the two years sees a swing that never happened.

An understated ending inventory works the same way with every direction reversed.

One caveat matters here: "it fixes itself" is not the same as "it does no harm". A lender who reads Year 1 alone sees too much profit.

Misconception check. Students often think an inventory error affects only the year in which it happens. It also moves the next year, in the opposite direction. The cure: whenever ending inventory is wrong, follow it into next year's beginning inventory.

Key terms

cost of goods available for sale — The total cost of all the goods a business could have sold in a period: the cost of its beginning inventory plus the cost of its purchases. (first used: 1. Add up what the shop could sell: the cost of goods available for sale)
inventory layer — A group of identical units a business bought at one unit cost, such as beginning inventory or one purchase, kept apart so its cost can be traced. (first used: 1. Add up what the shop could sell: the cost of goods available for sale)
cost flow assumption — A rule for deciding which unit costs move to cost of goods sold and which stay in ending inventory. It need not match the order in which the goods physically leave. (first used: 2. Choose a rule for the costs: the cost flow assumption)
specific identification — A costing method that tracks the actual cost of each unit sold, used for goods that are few, costly, and easy to tell apart. (first used: 3. Track each unit: specific identification)
first-in, first-out (FIFO) — A cost flow assumption under which the oldest unit costs are counted as sold first, so ending inventory carries the newest costs. (first used: 4. Send the oldest costs out first: FIFO)
last-in, first-out (LIFO) — A cost flow assumption under which the newest unit costs are counted as sold first, so ending inventory carries the oldest costs. (first used: 5. Send the newest costs out first: LIFO)
weighted average — A cost flow assumption that gives every unit the same average cost, found by dividing the cost of goods available for sale by the units available. (first used: 6. Spread one cost over every unit: weighted average)
consistency — The practice of applying the same accounting method from period to period so a business's statements can be compared, with the method disclosed to readers. (first used: 7. Compare the methods by their effects)
net realizable value — The amount a business expects to receive for its goods, less the costs to finish and sell them. (first used: 8. Follow two rules from their sources: LIFO and IFRS, and the lower of cost and net realizable value)
lower of cost and net realizable value — The rule that inventory measured by FIFO or average cost is reported at its cost or its net realizable value, whichever is lower, under the FASB's Accounting Standards Update No. 2015-11. (first used: 8. Follow two rules from their sources: LIFO and IFRS, and the lower of cost and net realizable value)
write-down — A reduction of an asset's reported amount to a lower measure, such as inventory reduced from its cost to its net realizable value, with the reduction reported as an expense of the period. (first used: 8. Follow two rules from their sources: LIFO and IFRS, and the lower of cost and net realizable value)
inventory error — A mistake in the amount of ending inventory. It misstates cost of goods sold and net income in that year and the opposite way in the next year, because one year's ending inventory is the next year's beginning inventory. (first used: 9. Trace an inventory error across two years)

Summary

Cost of goods sold plus ending inventory equals the cost of goods available for sale.
The helmets' cost of goods available for sale is $3,360 for 100 helmets.
A cost flow assumption assigns costs; it does not track which goods leave.
FIFO cost of goods sold is $2,280; LIFO's is $2,430; weighted average's is $2,352.
When costs rise, FIFO gives the lowest cost of goods sold and the highest gross profit.
LIFO gives cost of goods sold closer to current costs.
The methods are compared by their effects, never ranked.
A business applies one method consistently and discloses it.
IFRS does not allow LIFO; U.S. GAAP permits it.
FIFO ending inventory of $1,080 is written down by $60 to its $1,020 net realizable value.
An inventory error reverses itself next year, but both years are misstated.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A garden center starts the spring with 10 bags of soil that cost $5 each and buys 30 more at $8 each. It sells 25 bags. Compute cost of goods sold and ending inventory under FIFO.
Use the same garden center. Compute cost of goods sold and ending inventory under LIFO, and say in one sentence how the two methods' cost of goods sold compare.
A phone-accessory kiosk uses FIFO. Its ending inventory cost $2,400, and its net realizable value is $2,150. At what amount does the kiosk report its inventory, and how large is the write-down?
A bakery's year-end count wrongly leaves out a shelf of flour, so its ending inventory is understated. Explain what happens to its net income this year and next year.

Answers (worked reasoning — read after attempting)

The bags available are 10 + 30 = 40, costing 10 × $5 + 30 × $8 = 50 + 240 = $290. FIFO counts the oldest bags as sold first: all 10 at $5, then 15 at $8. Cost of goods sold is 10 × $5 + 15 × $8 = 50 + 120 = $170. The 15 bags left are from the $8 purchase, so ending inventory is 15 × $8 = $120. Check: 170 + 120 = $290.
LIFO counts the newest bags as sold first. All 25 sold bags come from the $8 purchase, so cost of goods sold is 25 × $8 = $200. The bags left are the 10 at $5 and 5 at $8, so ending inventory is 10 × $5 + 5 × $8 = 50 + 40 = $90. Check: 200 + 90 = $290. Costs rose from $5 to $8, so LIFO's cost of goods sold is 200 − 170 = $30 higher than FIFO's.
Under FIFO the kiosk reports the lower of cost and net realizable value. Cost is $2,400 and net realizable value is $2,150, so the lower amount is $2,150. The write-down is 2,400 − 2,150 = $250, an expense of the period.
Too little ending inventory means too much cost of goods sold this year, so this year's net income is understated. That low ending inventory becomes next year's beginning inventory, so next year's cost of goods sold is too low and its net income is overstated. The two-year total comes out right, but each year is wrong.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz; next week the five-component model of internal control joins your midterm review.

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