Methods of calculating inventory cost
As inventory is usually purchased at different rates (or manufactured at different costs) over an accounting period, there is a need to determine what cost needs to be assigned to inventory. For instance, if a company purchased inventory three times in a year at $50, $60 and $70, what cost must be attributed to inventory at the year end? Inventory cost at the end of an accounting period may be determined in the following ways:
- First In First Out (FIFO)
- Last In First Out (LIFO)
- Average Cost Method (AVCO)
- Actual Unit Cost Method
First In First Out (FIFO)
This method assumes that inventory purchased first is sold first. Therefore, inventory cost under FIFO method will be the cost of latest purchases. Consider the following example:
Example
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ $50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be calculated as follows:
The sales made on January 5 and 10 were clearly made from purchases on 1st January. Of the sales made on January 25, it will be assumed that 2 bikes relate to purchases on January 1 whereas the remaining one bike has been issued from the purchases on 15th January. Therefore, the value of inventory under FIFO is as follows:
| Date | Purchase | Issues | Closing Inventory | ||||||
|---|---|---|---|---|---|---|---|---|---|
|
|
Units |
$/Units |
Total |
Units |
$/Units |
Total |
Units |
$/Units |
Total |
|
Jan 1 |
5 |
50 |
250 |
- |
- |
- |
5 |
50 |
250 |
|
Jan 5 |
- |
- |
- |
2 |
50 |
100 |
3 |
50 |
150 |
|
Jan 10 |
- |
- |
- |
1 |
50 |
50 |
2 |
50 |
100 |
|
Jan 15 |
5 |
70 |
350 |
- |
- |
- |
5 |
70 |
350 |
|
Jan 15 |
- |
- |
- |
- |
- |
- |
7 |
- |
450 |
|
Jan 25 |
- |
- |
- |
2 |
50 |
100 |
- |
- |
- |
|
|
- |
- |
- |
1 |
70 |
70 |
4 |
70 |
280 |
As can be seen from above, the inventory cost under FIFO method relates to the cost of the latest purchases, i.e. $70.
Quiz
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Question
ABC Co. Ltd sells leather jackets. Due to the seasonal nature of the business, ABC Co sells its merchandise as soon as possible to avoid the risk of downward fluctuation in prices towards the end of the winter season. Which of the following methods is most suitable for the valuation of ABC Co’s inventories?
LIFO Method
Incorrect.
LIFO method values inventory on outdated prices. As a result, ABC Co's inventory may be significantly overstated from its market value if LIFO method is used. It is for this reason that the adoption of LIFO Method is not allowed under IAS 2 Inventories.
FIFO Method
Correct.
Since under FIFO method inventory is stated at the latest purchase cost, this will result in valuation of inventory at price that is relatively close to its current market worth. This should increase the relevance of accounting information.
Why accounting for inventory separate from purchase and sales accounting?
Every time a sale or purchase occurs, they are recorded in their respective ledger accounts. However, as we shall see in following sections, inventory is accounted for separately from purchases and sales through a single adjustment at the year end.
Theoretically, the cost of inventory sold could be determined in two ways. One is the standard way in which purchases during the period are adjusted for movements in inventory. The second way could be to adjust purchases and sales of inventory in the inventory ledger itself. The problem with this method is the need to measure value of sales every time a sale takes place (e.g. using FIFO, LIFO or AVCO methods). If accounting for sales and purchase is kept separate from accounting for inventory, the measurement of inventory need only be calculated once at the period end. This is a more practical and efficient approach to the accounting for inventory which is why it is the most common approach adopted.