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6.2: Inventory Cost Flow Assumptions

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    20100
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    • Contributed by Henry Dauderis and David Annand
    • Athabasca University
    • Sourced from Lyryx Learning

    learning objective

    LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first in first-out (FIFO), and weighted average cost flow assumptions — perpetual.

    Determining the cost of each unit of inventory, and thus the total cost of ending inventory on the balance sheet, can be challenging. Why? We know from Chapter 5 that the cost of inventory can be affected by discounts, returns, transportation costs, and shrinkage. Additionally, the purchase cost of an inventory item can be different from one purchase to the next. For example, the cost of coffee beans could be $5.00 a kilo in October and $7.00 a kilo in November. Finally, some types of inventory flow into and out of the warehouse in a specific sequence, while others do not. For example, milk would need to be managed so that the oldest milk is sold first. In contrast, a car dealership has no control over which vehicles are sold because customers make specific choices based on what is available. So how is the cost of a unit in merchandise inventory determined? There are several methods that can be used. Each method may result in a different cost, as described in the following sections.

    Assume a company sells only one product and uses the perpetual inventory system. It has no beginning inventory at June 1, 2015. The company purchased five units during June as shown in Figure 6.2.1.

    Purchase Transaction
    Date Number of units Price per unit
    June 1 1 $1
    5 1 2
    7 1 3
    21 1 4
    28 1 5
    5 $15

    Figure \(\PageIndex{1}\): June Purchases and Purchase Price per Unit

    The entry to record the June 30 sale on account would be:

    General Journal
    Date Account/Explanation F Debit Credit
    Accounts Receivable 40
    Sales 40
    To record the sale of merchandise on account.
    Cost of Goods Sold 11
    Merchandise Inventory 11
    To record the cost of the sale.

    It is not possible to use specific identification when inventory consists of a large number of similar, inexpensive items that cannot be easily differentiated. Consequently, a method of assigning costs to inventory items based on an assumed flow of goods can be adopted. Two such generally accepted methods, known as cost flow assumptions, are discussed next.

    The First-in, First-out (FIFO) Cost Flow Assumption

    First-in, first-out (FIFO) assumes that the first goods purchased are the first ones sold. A FIFO cost flow assumption makes sense when inventory consists of perishable items such as groceries and other time-sensitive goods.

    Using the information from the previous example, the first four units purchased are assumed to be the first four units sold under FIFO. The cost of the four units sold is $10 ($1 + $2 + $3 + $4). Sales still equal $40, so gross profit under FIFO is $30 ($40 – $10). The cost of the one remaining unit in ending inventory would be the cost of the fifth unit purchased ($5).

    The general ledger T-accounts for Merchandise Inventory and Cost of Goods Sold as illustrated in Figure 6.2.2 would show:

    imgb-1.png

    Figure \(\PageIndex{2}\): Cost of Goods Sold using FIFO

    The entry to record the sale would be:

    General Journal
    Date Account/Explanation F Debit Credit
    Accounts Receivable 40
    Sales 40
    To record the sale of merchandise on account.
    Cost of Goods Sold 10
    Merchandise Inventory 10
    To record the cost of the sale.

    The Weighted Average Cost Flow Assumption

    A weighted average cost flow is assumed when goods purchased on different dates are mixed with each other. The weighted average cost assumption is popular in practice because it is easy to calculate. It is also suitable when inventory is held in common storage facilities — for example, when several crude oil shipments are stored in one large holding tank. To calculate a weighted average, the total cost of all purchases of a particular inventory type is divided by the number of units purchased.

    To calculate the weighted average cost in our example, the purchase prices for all five units are totaled ($1 + $2 + $3 + $4 + $5 = $15) and divided by the total number of units purchased (5). The weighted average cost for each unit is $3 ($15/5). The weighted average cost of goods sold would be $12 (4 units @ $3). Sales still equal $40 resulting in a gross profit under weighted average of $28 ($40 – $12). The cost of the one remaining unit in ending inventory is $3.

    The general ledger T-accounts for Merchandise Inventory and Cost of Goods Sold are:

    imgc.png

    Figure \(\PageIndex{3}\): Cost of Goods Sold using Weighted Average

    The entry to record the sale would be:

    General Journal
    Date Account/Explanation F Debit Credit
    Accounts Receivable 40
    Sales 40
    To record the sale of merchandise on account.
    Cost of Goods Sold 12
    Merchandise Inventory 12
    To record the cost of the sale.

    Cost Flow Assumptions: A Comprehensive Example

    Recall that under the perpetual inventory system, cost of goods sold is calculated and recorded in the accounting system at the time when sales are recorded. In our simplified example, all sales occurred on June 30 after all inventory had been purchased. In reality, the purchase and sale of merchandise is continuous. To demonstrate the calculations when purchases and sales occur continuously throughout the accounting period, let's review a more comprehensive example.

    Assume the same example as above, except that sales of units occur as follows during June:

    Date Number of Units Sold
    June 3 1
    8 1
    23 1
    29 1

    To help with the calculation of cost of goods sold, an inventory record card will be used to track the individual transactions. This card records information about purchases such as the date, number of units purchased, and purchase cost per unit. It also records cost of goods sold information: the date of sale, number of units sold, and the cost of each unit sold. Finally, the card records the balance of units on hand, the cost of each unit held, and the total cost of the units on hand. A partially-completed inventory record card is shown in Figure 6.2.4 below:

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    Figure \(\PageIndex{4}\): Inventory Record Card

    In Figure 6.2.4, the inventory at the end of the accounting period is one unit. This is the number of units on hand according to the accounting records. A physical inventory count must still be done, generally at the end of the fiscal year, to verify the quantities actually on hand. As discussed in Chapter 5, any discrepancies identified by the physical inventory count are adjusted for as shrinkage.

    As purchases and sales are made, costs are assigned to the goods using the chosen cost flow assumption. This information is used to calculate the cost of goods sold amount for each sales transaction at the time of sale. These costs will vary depending on the inventory cost flow assumption used. As we will see in the next sections, the cost of sales may also vary depending on when sales occur.

    Comprehensive Example—Specific Identification

    To apply specific identification, we need information about which units were sold on each date. Assume that specific units were sold as detailed below.

    Date of Sale Specific Units Sold
    June 3 The unit sold on June 3 was purchased on June 1
    8 The unit sold on June 8 was purchased on June 7
    23 The unit sold on June 23 was purchased on June 5
    29 The unit sold on June 29 was purchased on June 28

    Using the information above to apply specific identification, the resulting inventory record card appears in Figure 6.2.5.


    imge.png

    Figure \(\PageIndex{5}\): Inventory Record Card using Specific Identification

    Notice in Figure 6.2.6 that the number of units sold plus the units in ending inventory equals the total units that were available for sale. This will always be true regardless of which inventory cost flow method is used.

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    Figure \(\PageIndex{6}\): Total Units Sold plus Total Units in Ending Inventory equals Total Units Available for Sale


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    Figure \(\PageIndex{7}\): Total Cost of Goods Sold plus Total Cost of Units in Ending Inventory equals Total Cost of Goods Available for Sale (Specific Identification)

    Figure 6.2.7 highlights the relationship in which total cost of goods sold plus total cost of ending inventory equals total cost of goods available for sale. This relationship will always be true for each of specific identification, FIFO, and weighted average.

    Comprehensive Example—FIFO (Perpetual)

    Using the same information, we now apply the FIFO cost flow assumption as shown in Figure 6.2.8.

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    Figure \(\PageIndex{8}\): Inventory Record Card using FIFO (Perpetual)

    When calculating the cost of the units sold in FIFO, the oldest unit in inventory will always be the first unit removed. For example, in Figure 6.2.8, on June 8, one unit is sold when the previous balance in inventory consisted of 2 units: 1 unit purchased on June 5 that cost $2 and 1 unit purchased on June 7 that cost $3. Because the unit costing $2 was in inventory first (before the June 7 unit costing $3), the cost assigned to the unit sold on June 8 is $2. Under FIFO, the first units into inventory are assumed to be the first units removed from inventory when calculating cost of goods sold. Therefore, under FIFO, ending inventory will always be the most recent units purchased. In Figure 6.2.8, there is one unit in ending inventory and it is assigned the $5 cost of the most recent purchase which was made on June 28.

    The information in Figure 6.2.8 is repeated in Figure 6.2.9 to reinforce that goods available for sale equals the sum of goods sold and ending inventory.


    imgi.png

    Figure \(\PageIndex{9}\): Total Goods Sold plus Ending Inventory equals Total Goods Available for Sale (FIFO Perpetual)

    Comprehensive Example—Weighted Average (Perpetual)

    The inventory record card transactions using weighted average costing are detailed in Figure 6.2.10. For consistency, all weighted average calculations will be rounded to two decimal places. When a perpetual inventory system is used, the weighted average is calculated each time a purchase is made. For example, after the June 7 purchase, the balance in inventory is 2 units with a total cost of $5.00 (1 unit at $2.00 + 1 unit at $3.00) resulting in an average cost per unit of $2.50 ($5.00 ÷ 2 units = $2.50). When a sale occurs, the cost of the sale is based on the most recent average cost per unit. For example, the cost of the sale on June 3 uses the $1.00 average cost per unit from June 1 while the cost of the sale on June 8 uses the $2.50 average cost per unit from June 7.


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    Figure \(\PageIndex{10}\): Inventory Record Card using Weighted Average Costing (Perpetual)

    A common error made by students when applying weighted average occurs when the unit costs are rounded. For example, on June 28, the average cost per unit is rounded to $4.13 ($8.25 ÷ 2 units = $4.125/unit rounded to $4.13). On June 29, the cost of the unit sold is $4.13, the June 28 average cost per unit. Care must be taken to recognize that the total remaining balance in inventory after the June 29 sale is $4.12, calculated as the June 28 ending inventory total dollar amount of $8.25 less the June 29 total cost of goods sold of $4.13. Students will often incorrectly use the average cost per unit, in this case $4.13, to calculate the ending inventory balance. Remember that the cost of goods sold plus the balance in inventory must equal the goods available for sale as highlighted in Figure 6.2.11.


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    Figure \(\PageIndex{11}\): Total Goods Sold plus Ending Inventory equals Total Goods Available for Sale (Weighted Average Perpetual)

    Figure 6.2.12 compares the results of the three cost flow methods. Goods available for sale, units sold, and units in ending inventory are the same regardless of which method is used. Because each cost flow method allocates the cost of goods available for sale in a particular way, the cost of goods sold and ending inventory values are different for each method.

    Cost Flow Assumption Total Cost of Goods Available for Sale Total Units Available for Sale Total Cost of Goods Sold Total Units Sold Total Cost of Ending Inventory Total Units in Ending Inventory
    Specific Identification $15.00 5 11.00 4 4.00 1
    FIFO 15.00 5 10.00 4 5.00 1
    Weighted Average 15.00 5 10.88 4 4.12 1

    Figure \(\PageIndex{12}\): Comparing Specific Identification, FIFO, and Weighted Average

    Journal Entries

    In Chapter 5 the journal entries to record the sale of merchandise were introduced. Chapter 5 showed how the dollar value included in these journal entries is determined. We now know that the information in the inventory record is used to prepare the journal entries in the general journal. For example, the credit sale on June 23 using weighted average costing would be recorded as follows (refer to Figure 6.2.12).

    General Journal
    Date Account/Explanation F Debit Credit
    Accounts Receivable 10.00
    Sales 10.00
    To record credit sale at a selling price of $10 per unit.
    Cost of Goods Sold 3.25
    Merchandise Inventory 3.25
    To record the cost of the sale.

    Perpetual inventory incorporates an internal control feature that is lost under the periodic inventory method. Losses resulting from theft and error can easily be determined when the actual quantity of goods on hand is counted and compared with the quantities shown in the inventory records as being on hand. It may seem that this advantage is offset by the time and expense required to continuously update inventory records, particularly where there are thousands of different items of various sizes on hand. However, computerization makes this record keeping easier and less expensive because the inventory accounting system can be tied in to the sales system so that inventory is updated whenever a sale is recorded.

    Inventory Record Card

    In a company such as a large drugstore or hardware chain, inventory consists of thousands of different products. For businesses that carry large volumes of many inventory types, the general ledger merchandise inventory account contains only summarized transactions of the purchases and sales. The detailed transactions for each type of inventory would be recorded in the underlying inventory record cards. The inventory record card is an example of a subsidiary ledger, more commonly called a subledger. The merchandise inventory subledger provides a detailed listing of type, amount, and total cost of all types of inventory held at a particular point in time. The sum of the balances on each inventory record card in the subledger would always equal the ending amount recorded in the Merchandise Inventory general ledger account. So a subledger contains the detail for each product in inventory while the general ledger account shows only a summary. In this way, the general ledger information is streamlined while allowing for detail to be available through the subledger. There are other types of subledgers: the accounts receivable subledger and the accounts payable subledger. These will be introduced in a subsequent chapter.

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