Lecture: Inventory Costing
Lecture script · about 15–20 minutes spoken · Week 7
Opening
Think about a hardware store whose paint costs a little more with every order. Or a coffee roaster whose bean prices swing with each harvest. Both of them buy the same item again and again, at different costs. Then they sell some of it. And someone has to decide which of those costs belongs to the goods that were sold. That decision is what we're going to work through together in this lecture.
Here's where we are. In Week 5 you built the classified balance sheet, where current assets are the items a business expects to turn into cash or use up within a year or its operating cycle. Inventory is one of those. In Week 6 the bicycle shop started selling bicycles, and you met Inventory, Cost of Goods Sold, gross profit, and the two ways of tracking goods, perpetual and periodic. Every bicycle cost the same $410, so cost of goods sold was one multiplication. That shop is illustrative, by the way. It's a made-up business we follow through the whole course.
This week the same item has three different costs. I'll take you through what the shop could have sold, the idea of a cost flow assumption, and four ways to apply it: specific identification, FIFO, LIFO, and weighted average. We'll compare their effects without picking a winner. Then we'll meet two rules from outside bodies, and finish with what an inventory error does over two years. Next week, in Midterm Review & Exam, you'll bring all of this to the midterm.
1. What the shop could have sold
Picture a jar of coins you add to all month. At the end of the month, the jar holds what you started with plus what you put in. A store's goods work the same way.
The bicycle shop sells helmets. It started the period with 20 helmets that cost $30 each, which is $600. Then it bought 40 helmets at $33 each, which is $1,320. Later it bought 40 more at $36 each, which is $1,440. Each of those groups is an inventory layer: a group of identical units a business bought at one unit cost, kept apart so its cost can be traced.
Add the layers and you get the 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. For the helmets, that's 100 helmets costing $3,360.
The shop sold 70 of them at $50 each, so sales were $3,500. That leaves 30 helmets on the shelf. Here's the key idea for the whole lecture. Every method you'll meet splits the same $3,360 into two parts. One part is cost of goods sold, for the 70 helmets sold, and it goes on the income statement. The other part is ending inventory, for the 30 helmets left, and it stays on the balance sheet.
Pause and try this. The shop's two purchases cost $1,320 and $1,440. Is cost of goods sold for the period the cost of those purchases?
Think about which helmets are still on the shelf.
Here's the answer. No. Cost of goods sold covers only the 70 helmets sold, and some of those came from beginning inventory, while 30 helmets' worth of cost is still sitting in Inventory.
So hold on to that check. Cost of goods sold plus ending inventory always comes back to $3,360.
2. A rule for the costs
At a grocery co-op, the bulk rice bin gets refilled from the top. New rice lands on old rice. The scoop takes whatever is on top. Nobody can tell one grain's price from another. But the co-op still has to say what the rice it sold cost.
So it uses a rule. 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 part matters more than anything else this week. The co-op could scoop from the top and still count its oldest costs as sold first. A cost flow assumption is an accounting convention, a choice that U.S. GAAP allows. It's not a description of the shelf. U.S. GAAP allows several, and we'll take four of them in turn.
Pause and try this. A shop always sells its oldest helmets first, because the boxes are stacked that way. Does that mean it has to use FIFO?
Give it a moment before you answer.
Here's the answer. No. FIFO and LIFO describe which costs are counted as sold, not which boxes leave, so the stacking on the shelf doesn't decide the method.
3. Tracking each unit
Some goods are easy to tell apart. A used guitar has a serial number. So does a hand-built bicycle frame. When each item is unique and costly, a business can keep track of what each one cost.
That's 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.
The chapter shows it with a used-instrument shop that owns three guitars. When it sells the guitar that cost $650 for $1,000, its cost of goods sold is that guitar's $650, and its gross profit is $350. No assumption is needed, because the shop knows exactly which guitar walked out the door.
The helmets aren't like that. They're identical, they're cheap, and there are 100 of them. Writing a cost inside each one would take more effort than the information is worth. So the bicycle shop uses one of the other three methods.
Pause and try this. Which fits specific identification better: the shop's 100 helmets, or a hand-built frame with its own serial number?
Picture tracking each one by hand.
Here's the answer. The hand-built frame, because it's one costly item you can tell apart from every other, while the helmets are many and identical.
4. First in, first out
Think about the eggs in your fridge. You use the ones you bought first, before they go bad. First in, 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.
Let's cost the 70 helmets by FIFO. We start with the oldest layer. All 20 beginning helmets at $30 come to $600. That's 20 helmets, and we need 50 more. Next, all 40 from the first purchase at $33 come to $1,320. That's 60 helmets, and we need 10 more. Last, 10 helmets from the second purchase at $36 come to $360. Add the three pieces and FIFO cost of goods sold is $2,280.
What's left? The 30 helmets from the second purchase, at $36 each. That's an ending inventory of $1,080. And $2,280 plus $1,080 brings us right back to $3,360. Gross profit is the $3,500 of sales minus $2,280, which is $1,220.
In one plain sentence: under FIFO the shop counts its oldest, cheapest helmets as sold, so the helmets left on the shelf carry the newest cost.
Pause and try this. Under FIFO, which layer do the 30 helmets in ending inventory come from?
Trace the order the costs went out.
Here's the answer. They come from the second purchase, at $36 each, because FIFO sends the oldest costs out first and the newest costs stay behind.
5. Last in, first out
Now picture a stack of plates in a cafeteria. Clean plates go on top, and diners take from the top. The last plate 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.
Same helmets, opposite order. We start with the newest layer. All 40 helmets from the second purchase at $36 come to $1,440. That's 40 helmets, and we need 30 more. Then 30 helmets from the first purchase at $33 come to $990. Add them and LIFO cost of goods sold is $2,430.
What's left this time is all 20 beginning helmets at $30, which is $600, plus 10 from the first purchase at $33, which is $330. So ending inventory is $930. And $2,430 plus $930 is $3,360 again. Gross profit is $3,500 minus $2,430, which is $1,070.
Here's a wrong turn I want you to see coming. A lot of people expect LIFO to give the lower cost of goods sold. When costs are rising, it gives the higher one. Each purchase cost more than the last, so the newest costs are the biggest, and LIFO sends them out first.
Pause and try this. For the helmets, which is larger: LIFO cost of goods sold or FIFO cost of goods sold?
Compare the two figures we've found so far.
Here's the answer. LIFO's $2,430 is larger than FIFO's $2,280, because the helmets' costs rose and LIFO counts the newest, costliest helmets as sold first.
6. One average cost
Imagine pouring three jugs of juice, each bought at a different price, into one pitcher. Every glass you pour from it now has the same blended cost.
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.
For the helmets, $3,360 divided by 100 helmets is $33.60 a helmet. Apply that to the 70 helmets sold and cost of goods sold is $2,352. Apply it to the 30 helmets left and ending inventory is $1,008. The two add back to $3,360. Gross profit is $3,500 minus $2,352, which is $1,148.
Why the word "weighted"? Because each layer counts by its size. If you averaged the three prices, $30, $33, and $36, you'd treat the 20-helmet layer as if it were as big as each 40-helmet layer. Dividing total cost by total units gives every helmet an equal say.
Pause and try this. Where does the weighted-average cost of goods sold, $2,352, fall compared with FIFO's $2,280 and LIFO's $2,430?
Line the three figures up in your head.
Here's the answer. It falls between them, because one blended cost sits between the oldest costs that FIFO sends out and the newest costs that LIFO sends out.
7. Comparing the methods by their effects
Let me line up all three. FIFO gives cost of goods sold of $2,280, ending inventory of $1,080, and gross profit of $1,220. LIFO gives $2,430, $930, and $1,070. Weighted average gives $2,352, $1,008, and $1,148.
When costs are rising, as they were for the helmets, a pattern shows up. 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. And the gap between FIFO and LIFO is $150, both in cost of goods sold and in gross profit.
Here's the 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 that sentence leaves out. It doesn't say which method is better. Each one is an allowed choice under U.S. GAAP. FIFO's balance sheet figure sits closer to recent costs, and LIFO's income statement figure sits closer to recent costs. That's a trade, and in this course we describe it rather than judge it.
Whatever method a business picks, it keeps. 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. Switching isn't free. A reader comparing two years could mistake the switch for a change in the business itself.
Pause and try this. A coffee roaster's bean costs fell with every order. Would FIFO send its highest costs or its lowest costs to cost of goods sold first?
Turn the helmet pattern around.
Here's the answer. Its highest costs, because when costs fall the oldest beans are the costliest, and FIFO counts the oldest costs as sold first.
8. Two rules from their sources
Two rules this week come from outside bodies, and I'll state each one the way its source does.
The first is about LIFO. IFRS does not allow LIFO, as the SEC stated in 2008 in its Release No. 33-8982. U.S. GAAP permits it. That's a documented rule, not a debate. In Week 1 you compared the two frameworks without ranking them, and this is one plain place where they differ.
The second rule is about value. Suppose a newer helmet model arrives, and shoppers won't pay full price for the old one anymore. The helmets on the shelf might now bring in less than they cost. Net realizable value is the amount a business expects to receive for its goods, less the costs to finish and sell them. And 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. LIFO and the retail method stay under an earlier rule called lower of cost or market, and you only need its name this week.
Say the shop expects $34 a helmet, after selling costs. The 30 helmets are worth $1,020. FIFO ending inventory cost $1,080, which is higher, so the shop writes it down by $60 and reports $1,020. That's a write-down: a reduction of an asset's reported amount to a lower measure, with the reduction reported as an expense of the period.
Pause and try this. Under weighted average, ending inventory cost $1,008. Does it need a write-down to the $1,020 net realizable value?
Ask which of the two amounts is lower.
Here's the answer. No, because $1,008 is already below $1,020, so cost is the lower amount and the inventory stays at cost.
9. An inventory error across two years
Picture two dominoes in a row. Tip the first and the second one moves too. An inventory count works that 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.
Let's walk one in words. Say a year-end count includes boxes that were already sold, so ending inventory is too high. Cost of goods sold is what was available minus what's left. Too much left means too little cost of goods sold, so this year's net income comes out too high. Then that same overstated figure becomes next year's beginning inventory. Too much at the start means too much cost of goods sold next year, so next year's net income comes out too low. Over the two years the errors offset. But each year on its own is wrong, and a lender who reads only the first year sees profit that wasn't there.
Pause and try this. If a year-end count leaves out a shelf of goods, is that year's net income too high or too low?
Follow the missing goods into cost of goods sold.
Here's the answer. Too low, because too little ending inventory means too much cost of goods sold, and the error flips the other way the next year.
Closing
Let's pull it together. The cost of goods available for sale, $3,360 for the helmets, is the pool every method splits. A cost flow assumption assigns costs, and it doesn't track which boxes leave. Specific identification follows each unit's actual cost, which fits a few costly, unique items. FIFO gave the helmets cost of goods sold of $2,280, LIFO gave $2,430, and weighted average gave $2,352. When costs rise, FIFO shows the lowest cost of goods sold and the highest gross profit, and LIFO's cost of goods sold sits closer to current costs. We describe those effects and never rank them, and a business applies its method consistently and discloses it. IFRS does not allow LIFO, while U.S. GAAP permits it. FIFO ending inventory of $1,080 was written down by $60 to $1,020. And an inventory error moves two years, in opposite directions.
Next in this module, read the Readings and Resources page, then work through the lecture tutorial, the practice set, and the quiz, and bring your questions to the discussion, the assignment, and the Accounting Workshop. Next week, in Midterm Review & Exam, we review Weeks 1 to 7 by the one distinction each topic asks for and add internal control.
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