10 Inventory
Tracking Systems and Valuation Techniques
Inventory costing: how do we determine the cost of each inventory unit?
In all of the examples so far you have calculated units: either units of ending inventory or the number of units sold. Then you’ve multiplied by the cost per unit. Now the question is: how do we figure out the cost assigned to each unit? In this section we will calculate inventory cost.
The first step is to decide whether products are separately identifiable. We can decide this by looking at the company’s business model. Some questions that might indicate separately identifiable inventory are:
- Is the company’s business model to sell custom made product? If yes, the cost of each product will be different depending on customization and needs to be tracked separately so it can been sold at an appropriate price. An example of this type of business model is home builders.
- Does the company sell high-value, unique inventory? If yes, the cost of each product may differ depending on when it was purchased. Because the company will have very few pieces of inventory on hand, and these may be identified separately. An example of this type of business model is sellers of precious jewels.
- Is inventory marked with a serial number or other unique marking? If yes, the cost of each product can be tracked in the accounting system using this unique identifier. An example of this type of business model is car dealerships.
Products are worth tracking individually because they are high value or unique. These products are often marked with serial numbers and each serial number is associated with the cost of purchasing that unit. But this is not always the case. Land developers or home builders will use addresses to identify their inventory. When a product is identified by a unique identifier its cost can be referenced by this identifier. This way, when the product is sold, the company can assign a unit cost exactly equal to the cost that was paid for the product.
On the other hand, a company may have a business of selling goods that are similar in nature and cost. There’s a word that describes this similarity between units: homogeneity. We’ve assumed inventory homogeneity in our previous examples: books and coffee beans. Other examples may include t-shirts, office supplies such as pencils, paper, crayons, or staplers; petroleum products; or bottled drinks like cans of coke or bottles of water. Where inventory is homogenous, meaning units all have the same design, it doesn’t make sense to track of the cost of each physical inventory unit. In fact, it probably isn’t practical because there is no serial number or special marking to differentiate one inventory unit from another. How should a company assign costs to homogenous inventory? There are two options: first-in-first-out (FIFO) and weighted average costing. Each inventory costing method is based on a unique assumption and results in different value for ending inventory and cost of goods sold.
Let’s take a look at two scenarios:
Scenario 1: Pretend that a company has a warehouse with a front and back door. Inventory enters through one door when the company purchases it and marches through the warehouse until it reaches the opposite door and is sold. Each unit is assigned a cost when it enters, and the oldest inventory is sold first. But that with homogenous inventory we can’t track the specific inventory. We can only track the costs. There are a couple benefits of FIFO: (1) inventory costs are close to replacement cost which is the current cost of inventory, and (2) simplicity and mathematical ease!
Scenario 2: Pretend that inventory is tossed into a warehouse with no way to identify it. In this case it makes sense to measure the total value of all inventory in the warehouse and divide by the number of units. The average cost method assigns cost using a running average cost of inventory. So as inventory cost goes up, the cost of all inventory in the warehouse will instantly increase; and the opposite is true if inventory cost goes down. Because the accounting cost of inventory reacts immediately to the purchase price of inventory, it allows companies to react more quickly with sales price adjustments.
Think about gross profit, which is equal to sales revenue less cost of goods sold. If customers pay the same sales price for our goods, but the price of the inventory changes, FIFO will result in high gross profit until the higher cost batch is sold. The benefit of average cost is that it provides an early indication of changes in price and a gradual impact on cost of goods sold. The disadvantage of average cost is its computational complexity. However, most point-of-sale systems compute average inventory costs easily and integrate directly with accounting programs.
Below is a table with the assumptions, application and financial statement effects of each method.
|
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FIFO (First-In First-Out) |
Average Cost |
|
Assumption |
Oldest inventory is sold first and most recent inventory is retained. |
All inventory is the same, therefore cost of all inventory units should be the same. |
|
Application |
Although all inventory units are indistinguishable from one another, and therefore the oldest inventory may not be physically sold first, the company records batches of inventory units by purchase cost. Then the company transfers the cost from the oldest batch to cost of goods sold. Once costs from the oldest batch have been transferred, the company moves on to the next oldest batch, and so forth. |
Cost of all units purchased is averaged and the same average cost is assigned to all units in inventory. This is a moving average which increases or decreases depending on whether the unit cost of inventory purchased is higher or lower than the current average cost of inventory. |
|
Impact on Statement of Financial Position |
Because the inventory account always holds the most recent costs, in a period of rising costs FIFO will result in a higher inventory value than average cost. This is good because the Statement of Financial Position reflects the most up to date inventory cost. In a period of falling inventory cost, FIFO will result in a lower inventory value than average cost and will still reflect the most up to date inventory cost. |
Because the inventory account reflects an average of historical prices, in a period of rising costs, average cost will result in a lower inventory value than FIFO. This makes sense because the increase in cost is spread between inventory and cost of goods sold. This effect is mechanical in that the average cost is revised after every purchase. The opposite is true in a period of falling inventory cost and just a mathematical reality. |
|
Impact on Statement of Financial Position |
Because the oldest inventory is sold first, the oldest inventory costs are held in the cost of goods sold account. This means that in a period of rising inventory costs, FIFO will result in a lower cost of goods sold than average cost. Think of it this way, if beginning inventory is zero, we’re allocating the same purchase costs between ending inventory and cost of goods sold. This is evident in the diagram earlier in this chapter. That means if FIFO yields a higher ending inventory value than average cost, cost of goods sold must be lower under FIFO – it’s a mathematical fact! Of course, the opposite will be true for periods of decreasing inventory costs. |
Because cost of goods sold includes both old and newer costs averaged together, and FIFO includes only the oldest costs, in a period of rising costs average cost will result in higher cost of goods sold. The opposite is true in a period of reducing costs. |
Let’s calculate inventory costs using examples. Here are two examples of FIFO followed by the same examples using average cost. As always, I’ll do the first one then give you an opportunity to try.
