Chapter 6 — Inventory Costing: FIFO, LIFO & Average

Inventory and why the cost matters

Inventory is the goods a company holds for resale. For a merchandiser it's one line — merchandise inventory. The whole chapter is about one question: of all the goods a company bought this period, how much cost stays on the balance sheet as ending inventory, and how much flows to the income statement as cost of goods sold?

The split is: Cost of goods available for sale = Ending inventory + Cost of goods sold. Value the ending inventory and the cost of goods sold falls out of the same total — so every dollar you put in one comes out of the other.

Which goods do you actually own?

Before you can count inventory you have to know which goods belong to you at year-end. Two situations trip people up: goods in transit and goods on consignment.

Specific identification

If you can tell each unit apart — think cars by VIN, or fine jewelry — you can track the actual cost of the exact unit sold. That's specific identification. It's precise but only practical for low-volume, high-value, distinguishable goods.

Most businesses can't track thousands of identical units this way, so they make a cost-flow ASSUMPTION instead — FIFO, LIFO, or average-cost. The assumption is about which costs flow out; it need not match the physical flow of the goods.

Cost-flow assumptions (periodic): FIFO, LIFO, average

Under the periodic system you compute the three methods at period end from the pool of goods available for sale. Same goods, three different splits between ending inventory and cost of goods sold.

Cost-flow assumptions (perpetual): the moving-average twist

Under the perpetual system you assign a cost to each sale as it happens. FIFO and LIFO work the same way but are applied at each sale from the layers on hand. Average-cost becomes MOVING-average: you recompute the average after every purchase.

Note LIFO can give different answers under periodic vs. perpetual because perpetual locks in the 'last' cost available at each sale, while periodic waits until the end of the period.

Which method, and why it matters

When prices are RISING, the three methods pull the numbers in predictable directions. Knowing this cold is worth several exam points.

• FIFO → lowest cost of goods sold, so HIGHEST net income and HIGHEST ending inventory (and highest income taxes).
• LIFO → highest cost of goods sold, so LOWEST net income and LOWEST ending inventory (its appeal is the LOWEST income taxes).
• Average-cost → falls between FIFO and LIFO on every measure.

There's also a quality argument: FIFO's ending inventory is priced at the most recent costs, so it best approximates current cost on the BALANCE SHEET. LIFO's cost of goods sold is priced at the most recent costs, so it best matches current cost against revenue on the INCOME STATEMENT.

Lower-of-cost-or-market

Inventory is normally carried at cost, but if its market value (net realizable value) falls below cost, accounting's conservatism says write it down. This is the lower-of-cost-or-market (LCM) rule, applied item by item.

You never write inventory UP above cost under LCM — only down. The loss hits income in the period the value falls.

Inventory errors and how they unwind

Because ending inventory is subtracted to get cost of goods sold, an error in the count ripples straight through to net income — and then reverses next period.

• Overstate ending inventory → understate COGS → OVERSTATE net income this period.
• Understate ending inventory → overstate COGS → UNDERSTATE net income this period.
• This period's ending inventory is next period's BEGINNING inventory, so the error flips: the next period's net income is misstated the opposite way.

Estimating inventory: the gross profit method

Sometimes you need an inventory figure without a physical count — for monthly statements, or when the inventory is destroyed in a fire. The gross profit method estimates it using the company's normal gross profit rate.

• Estimated cost of goods sold = Net sales × (1 − gross profit rate).
• Estimated ending inventory = Cost of goods available for sale − estimated cost of goods sold.

Estimating inventory: the retail method

Retailers who track goods at selling price use the retail inventory method. The trick is a cost-to-retail ratio that converts a retail-dollar ending inventory back to cost.

• Cost-to-retail ratio = goods available at COST ÷ goods available at RETAIL.
• Ending inventory at retail = goods available at retail − net sales.
• Ending inventory at cost = ending inventory at retail × cost-to-retail ratio.

Analyzing inventory: turnover and days

Managers and investors watch how fast inventory sells. Two ratios do the job.