Question

List and describe the four methods used to account for inventory?

What effect does each inventory method used have on the firm’s reported profits and ending inventory levels?

Which inventory method should be used if management anticipates a period of inflation? Why?

What are some specific inventory carrying costs? Are these costs fixed or variable?

Answer 1

1)There are four accepted methods of costing inventory items:

1. specific identification;
2. first-in, first-out (FIFO);
3. last-in, first-out (LIFO); and
4. weighted-average.

Each method has advantages and disadvantages. Note that a manufacturing business’s inventory will consist of work in process, or unfinished goods, and finished inventory; the costs of unfinished and finished inventory contain a combination of costs related to raw materials, labor, and overhead. On the other hand, a retailer’s inventory consists of all finished products purchased from a wholesaler or manufacturer; the costs of their units are based on their acquisition cost rather than the costs associated with manufacturing units.

Specific Identification

The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

FIFO (first-in, first-out)

The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

LIFO (last-in, first-out)

The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.

Weighted-average

The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them.

2) The disadvantages of FIFO include the recognition of paper profits by assigning excess value to the inventory and thereby increasing the tax burden. LIFO grossly understates inventory by taking the cost of first inventory for the valuation of inventory thereby understating the profit. If there is huge variation in the cost of the product it will affect the inventory valuation using Weighted average method and thereby affect the profit. In specific identification method the chances of excess or short valuation of inventory is lesser compared to other methods, but the cost incidental to the identification of cost specific items will higher and affect the profit.

3) During periods of inflation, FIFO inventory accounting Yields lower cost of goods sold values than LIFO

4) Inventory carrying cost, also known as inventory holding cost, is the cost associated with holding inventory or stock in storage or a warehouse, in order to fulfill sales orders. They are

a. Capital costs

Capital costs refer to the costs incurred for carrying inventory. Examples include money spent on acquiring goods, interest paid on a purchase, interest lost when cash turns into inventory, as well as the opportunity cost of purchasing inventory. Capital cost usually makes up the largest portion of the total carrying cost.

b. Storage costs

Storage costs are expenses incurred to help keep your inventory safely organized in a particular place like your warehouse. It can be separated into two components: fixed costs and variable costs.

Fixed costs include rent or mortgage costs of the storage space, while variable costs are manpower costs, costs of handling materials and utilities expenses associated with the space.

c. Service costs

Service costs are incurred to protect your inventory from issues such as theft or workplace accidents, to ensure that government regulations are met and to keep your inventory well managed. Examples include insurance payments, taxes on inventory, as well as the costs of using an inventory management software system to keep track of inventory level

d. Costs of inventory risk

Carrying inventory presents a certain level of risk, and this risk translates into a cost component. This cost component is made up of a few factors. The first factor is the risk of shrinkage, which refers to any inventory loss that occurs after a good is purchased, and before it is sold to your customer. Shrinkage may occur to due to damages in transit, administrative errors or theft by employees.