Question

• Identify four methods of assigning a cost to ending inventory and cost of goods sold and briefly explain the difference in the methods.
  
• It’s common in the electronics industry for unit costs of raw materials inventories to decline over time. In this environment, explain the difference between LIFO and FIFO, in terms of the effect on income and financial position. Assume that inventory quantities remain the same for the period.
  
• Explain why proponents of LIFO argue that it provides a better match of revenue and expenses. In what situation would it not provide a better match?

Answer 1

The four methods of assigning cost to ending inventory and cost of goods sold are as follows:

LIFO (Last in First Out Method) - Under LIFO, goods that are taken in inventory last are sold first. Thus, the cost of inventory is valued on the basis of items remaining in inventory which were purchased at older costs. Costs of goods sold are the goods that were purchased last.

FIFO (First in First Out Method) - Under FIFO, goods that are taken in inventory first are sold first. Thus, the cost of inventory is valued on the basis of items remaining in inventory which were purchased at latest costs. Costs of goods sold are the goods that were purchased first.

Weighted Average Method - This method involves aggregating the purchase price paid for each entry and then dividing by the aggregate quantity. Weighted Average method is the most scientifically used method in inventory valuation. Cost of goods sold will be valued at same basis in this method.

Specific Identification Method - This method identifies each item in inventory at it's specific costs and assigns the same in cost of goods sold in case of sale. This kind of method is more suitable for instances which have unique or customized items based on customer's requirements.

In electronics industry, the inventory loses it's value due to technical obsolescence. The older the inventory gets, the lesser are it's chances of sale and hence there's a requirement to write them off once they're older beyond the average sales period. LIFO method might be more prevalent here since the latest purchased item will also have the latest technology and it's chances of sale are much better than the older ones.

In case of rising prices, LIFO is a better method as the higher cost items are considered sold first, thus reducing the cost of inventory at the end of the period. LIFO helps reduce tax burden and match revenue to cost.

Disadvantages of LIFO

• LIFO might be more difficult to maintain because it means that the oldest item was never sold or shipped.
• It also increases the ageing of inventory calling for higher provisioning and write-offs.
• LIFO might not be suitable in case of falling prices.