Question

Inventory Discussion

Compare and contrast the three different inventory costing methods: LIFO, FIFO and weighted average cost. Additionally, give an example of a reason why one company might use one of these methods.

Answer 1

a) LIFO Method:

Last In First-Out is one of the common techniques used in valuation of inventory on hand at the end of a period and the cost of goods sold during the period. LIFO assumes that goods which made their way to inventory (after purchase, manufacture etc.) later are sold first and those which are manufactured or acquired early are sold last. Thus LIFO assigns the cost of newer inventory to cost of goods sold and cost of older inventory to ending inventory account. This method is exactly opposite to first-in, first-out method.

b) FIFO Method:

First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value of inventory on hand at the end of an accounting period and the cost of goods sold during the period. This method assumes that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern.

c) Weighted Average Method:

The weighted average method is used to assign the average cost of production to a product. Weighted average costing is commonly used in situations where:

1) Inventory items are so intermingled that it is impossible to assign a specific cost to an individual unit.
2) The accounting system is not sufficiently sophisticated to track FIFO or LIFO inventory layers.
3) Inventory items are so commoditized (i.e., identical to each other) that there is no way to assign a cost to an individual unit.

When using the weighted average method, divide the cost of goods available for sale by the number of units available for sale, which yields the weighted-average cost per unit. In this calculation, the cost of goods available for sale is the sum of beginning inventory and net purchases. You then use this weighted-average figure to assign a cost to both ending inventory and the cost of goods sold.

Example:

transactions during July:

July 1 Purchases 1,200 Chocolates at $1 each.
July 13 Purchases 500 Chocolates at $1.20 each.
July 14 Sells 700 Chocolates at $2 each.

First of all, how many Chocolates does she have at the end of the month and calculate the value of inventory using each method?

Units will be 1200+500-700=1000 chocolate in unit

a) under FIFO Calculation

This method assumes that the first inventories bought are the first ones to be sold and that inventories bought later are sold later.

The Value of our closing inventory in this example would be calculated as follows:

Date	Details	Number	$/Unit	Value
1-Jul	Purchases 1200 Chocolates at $1 each	1,200	$         1.0	$        1,200
13-Jul	Purchases 500 Chocolates at $1.20 each	1,200	$         1.0	$        1,200
		500	$         1.2	$           600
		1,700	n/a	$        1,800
14-Jul	Sells 700 chocolates at $2 each	500	$         1.0	$           500
		500	$         1.2	$           600
		1,000	n/a	$        1,100

Using FIFO method our closing inventory comes to $1,100. This equates to the cost of $1.10 per chocolate ( $1,100/1,000 chocolates)

b) under LIFO Calculation

This method assumes that the last inventories bought are the first one to be sold and that inventories bought first are sold last.

The Value of our closing inventory in this example would be calculated as follows:

Date	Details	Number	$/Unit	Value
1-Jul	Purchases 1200 Chocolates at $1 each	1,200	$         1.0	$        1,200
13-Jul	Purchases 500 Chocolates at $1.20 each	1,200	$         1.0	$        1,200
		500	$         1.2	$           600
		1,700	n/a	$        1,800
14-Jul	Sells 700 chocolates at $2 each	1,000	$         1.0	$        1,000
		-	$         1.2	$               -
		1,000	n/a	$        1,000

Using LIFO method our inventory comes to $1,000. This equates to a cost of $1.00 per chocolate ($1,000/1,000 chocolates)

c) Under weighted average method:

Date	Details	Number	$/Unit	Value
1-Jul	Purchases 1200 Chocolates at $1 each	1,200	$         1.0	$        1,200
13-Jul	Purchases 500 Chocolates at $1.20 each	1,200	$         1.0	$        1,200
		500	$         1.2	$           600
		1,700	$       1.06	$        1,800
Therefore, average cost per chocolate is $1,800/1,700 chocolates, which comes to $1.06
14-Jul	Sells 700 chocolates at $2 each	1,000	$       1.06	$        1,059

Using weighted average method our closing inventory comes to $1,059. This equates to a cost of $1.06 per chocolate ($1,059/1,000 chocolates).

Therefore a company can choose one among the above methods which is best for a particular industry in reporting fair values as the value differs from method to method.

Thank you.