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Inventories and Cost of Goods Sold
The cost of goods sold is the price paid by the company for the materials it used in making its product, which it then sold. The cost of goods is most easily determined through inventory calculations. There are two methods of calculating inventory. They are
The Periodic Inventory System
Under this system, the records are updated periodically to reflect the results of physical counts. This system is generally used in instances of high quantity, low value items.
The Perpetual Inventory System
This system involves maintaining continuous records of the amount of inventory that is on hand and that has been sold. This system would be used with low quantity, higher value items.
Determination of the Cost of Goods Sold
To determine the cost of goods sold for a given period, there are four different methods. These include the specific invoice prices method; the weighted-average method; the first-in, first-out method; and the last-in, first-out method.
In order to illustrate each of these methods, we shall do an example question:
There are 12 units on hand at the end of the period. The following information is provided:
| January 1 | Beginning Inventory | 10 units @ $100 each | $1,000 |
| March 13 | Purchased | 15 units @ $108 each | $1,620 |
| August 17 | Purchased | 20 units @ $120 each | $2,400 |
| November 10 | Purchased | 10 units @ $125 each | $1,250 |
| Total | $6,270 |
Solve using each method:
Specific Invoice Prices Method
To use this method, we will always be provided with certain data. For this example, assume that 6 of the 12 units on hand at the end of the period were from the November purchase, while 6 were from the August purchase.
| Total Available Units Cost | = $6,270 |
|
| Less Ending Inventory: | ||
| 6 units from November purchase | @ $125 each | = $750 |
| 6 units from August purchase | @ $120 each | = $720 |
| Ending Inventory | = $750 + $720 | = $1,470 |
| Cost of Goods Sold | = $6,270 - $1,470 | = $4,800 |
Weighted-Average Method
To calculate the weighted-average, we take the total cost of the units, $6,270, and divide it by the total number of units, 55. This gives us a value of $114 for an average cost of the units. We then use that cost as the value of the 12 units we have on hand.
| Total Available Units Cost | = $6,270 |
|
| Less Ending Inventory: | ||
| 12 units | @ $114 each | = $1,368 |
| Ending Inventory | = $1,368 | |
| Cost of Goods Sold | = $6,270- $1,368 | = $4,902 |
First-in, First-out / FIFO Method
The FIFO Method works under the assumption that the first goods you bring into the company are the first ones you sell. In this example, that means that we would sell the beginning inventory first, followed by the January purchases, and so on. So, our ending inventory contains those units that we most recently purchased.
| Total Available Units Cost | = $6,270 |
|
| Less Ending Inventory: | ||
| 10 units from November purchase | @ $125 each | = $1,250 |
| 2 units from August purchase | @ $120 each | = $240 |
| Ending Inventory | = $1,250 + $240 | = $1,490 |
| Cost of Goods Sold | = $6,270 - $1,490 | = $4,780 |
Last-in, First-out / LIFO Method
This method assumes that the last items purchased are the first to be sold. This means that the items purchased in November are the first to be sold, followed by the August purchases, and so on. Therefore, the units that we have as ending inventory are those units that we first purchased.
| Total Available Units Cost | = $6,270 |
|
| Less Ending Inventory: | ||
| 10 units from Beginning Inventory | @ $100 each | = $1,000 |
| 2 units from January purchase | @$108 each | = $216 |
| Ending Inventory | = $1,000 + $216 | = $1,216 |
| Cost of Goods Sold | = $6,270 - $1,216 | = $5,054 |
From the above examples, there are only small differences in the cost of goods sold calculations using the different methods. This will normally be the case when the economy is stable. However, in an unstable economy, when prices can fluctuate greatly, these methods can produce large variations.
Due to the fact that these methods can be used to calculate differing values of the cost of goods sold, companies must abide by the Consistency Principle. This principle assures that companies use only one method for their calculations from period to period.