Inventory

Inventory Systems and Inventory Costing Methods

Perpetual Inventory System

Under the perpetual inventory system, inventory is constantly valued, maintained, and recalculated with each new purchase of inventory.

In a perpetual inventory system, each sale and purchase transaction related to merchandise is recorded directly to the inventory account as well as the corresponding subsidiary ledger as records are constantly updated in real time. Inventory can be tracked using various means, such as real-time databases, bar-code scanners, and point-of-sale terminals. Thus, the amount of inventory on hand and available is always current. In order to properly establish an inventory costing system, it is important to note this fact because it will be a consideration in determining how costs flow.

Under the perpetual cost system, depending on when the goods are sold, the company may have to use different cost points. For example, if the company sells 5 units on 3/30/18, then the range of costs is between $1.25 and $1.40. However, if the company sells 5 units on 4/30/18, then the range of costs is now between $1.25 and $1.55. It is important for the accountant to note the date of the sales and the date of the purchases. Therefore, with each sale or purchase, the accountant has a new basis on which to determine the cost of each unit. As such, the cost of sales is calculated on a rolling basis to provide updated information as needed.

Perpetual Sale of Goods Illustration

Under the perpetual inventory system, the inventory account is constantly up to date. Therefore, with each sale or purchase, the accountant has a new basis from which to determine the cost of the unit.

Periodic Inventory System

Under the periodic inventory system, inventory records are updated when a physical count of goods on hand is done, whereas under the perpetual inventory system, inventory records are constantly updated.

When using the periodic inventory system, a business's records are updated when a physical count of the inventory on hand is done, after everything has been counted. The inventory account is not systematically updated throughout a period, as is done when using the perpetual inventory system. The process of physical counting takes time, even with the aid of scanning devices and computers. So, with the periodic inventory system, the count may be done when merchandise inventory is low, perhaps during the off-season when there is less to count. Doing a physical count can serve as an accuracy check for a merchandising business using the perpetual inventory system. However, because inventory numbers are not updated until period-end, current sales and purchases data throughout the period would not be available in real time for determining the cost of units. Costs would be determined at the end of the designated period—often yearly—after the physical inventory is conducted. Just the ending inventory balance is updated in the general ledger.

For example, Company ABC starts with a beginning inventory of 10 units. Goods are purchased and sold throughout the period of one month—January. Relevant information to determine the cost of the goods sold includes the amount of sales, the gross profit, and the amount that will remain in inventory at the end of the month.

Information to Determine COGS with the Periodic FIFO Method

Date Description Units Cost Total Cost
Jan. 1 Beginning inventory 10 $1.25 $12.50
Jan. 10 Purchase 5 $1.35 $6.75
Jan. 30 Purchase 6 $1.45 $8.70
Jan. 31 Total goods available 21 $27.95
Jan. 31 Less physical inventory 9 $11.98
Jan. 31 Cost of goods sold 12 $15.97

FIFO Method of Valuing Inventory

In a period of rising prices, the first in, first out (FIFO) method allows an organization to record lower inventory costs (cost of goods sold) on the income statement and higher amounts of inventory on the balance sheet.

With the FIFO inventory valuation system, the units that are purchased first will be the first to be sold. The physical flow of the units is not followed, but the flow of costs is followed. The first set of costs acquired will be the first costs used in determining the cost of the goods sold.

For example, assume that Company ABC is using the perpetual inventory system. Its beginning inventory includes 10 units. Goods are purchased and sold throughout the period of one month—January. Relevant information to determine the cost of the goods sold includes the amount of sales, the gross profit, and the amount that will remain in inventory at the end of the month.

Information to Determine COGS with the Perpetual FIFO Method

Date Description Units Cost Total Cost
Jan. 1 Beginning inventory 10 $1.25 $12.50
Jan. 4 Sale at $3.00/unit 7
Jan. 10 Purchase 5 $1.35 $6.75
Jan. 22 Sale at $3.00/unit 3
Jan. 28 Sale at $3.00/unit 2
Jan. 30 Purchase 6 $1.45 $8.70

Cost Flow Example

Using the first-in, first-out (FIFO) method, the flow of costs is followed to determine cost of goods sold, not the physical flow of units.
This illustration provides the same information found in the previous information table. In this illustration of cost flow, the beginning inventory and purchases are separated from the sales. This is important because the goal is to determine the proper costs of the inventory sold. The sale dates and number of units of goods sold determine which cost level will be used to arrive at the cost of goods sold. Referring to the table, at each sale the accountant must determine which goods are still currently available for sale. For the first sale of 7 units on 1/4/18 shown in the previous table, only 10 items are available in the beginning inventory. The 5 units purchased on 1/10/2018 and 6 units purchased on 1/30/2018 would not be relevant for the sale on 1/4/18, because those purchases have not occurred yet. Therefore, all 7 units purchased would have to come from the beginning inventory, which was bought at $1.25 per unit. As you can see in the next illustration, 3 units sold on 1/22/18 come from the remaining beginning inventory units. The 2 units sold on 1/28/18 come from the purchased units on 1/10/2018. The FIFO method starts from the top with the oldest costs, the first ones in.

FIFO Example

The first-in, first-out (FIFO) cost flow starts from the top down. The first units (7 units) that are assumed to be sold are the oldest units with the oldest costs: in this case, $1.25 per unit.
Therefore, the cost of goods sold under the FIFO method would comprise all of the beginning inventory units and 2 units from the 1/10/2018 purchase. The remaining 3 units purchased on 1/10/2018 as well as the goods purchased on 1/30/2018 would be left over in ending inventory.

Valuing Inventory Using FIFO Method

FIFO
Summary
Date Description Units Cost Total Cost
Jan. 1 Beginning inventory 10 $1.25 $12.50
Jan. 10 Purchase 2 $1.35 $2.70
Total Cost of Goods Sold $15.20
Jan. 10 Purchase 3 $1.35 $4.05
Jan. 30 Purchase 6 $1.45 $8.70
Remaining Goods (Ending Inventory) $12.75

Remember: the ending inventory now consists of 3 units at $1.35 each and 6 units at $1.45 each that will become the beginning inventory in the next period of a month. Thus, February begins with two different cost levels of inventory—$1.35 and $1.45.

LIFO Method of Valuing Inventory

In a period of rising prices, the last in, first out (LIFO) method allows an organization to record higher inventory costs (cost of goods sold) on the income statement and lower amounts of inventory on the balance sheet.
The LIFO method of inventory valuation in some respects will be the opposite of FIFO. However, the challenge with using LIFO in a perpetual inventory system is that when using the most recent costs acquired, as new purchases are made, the cost levels used will always change.

LIFO Example

The last-in, first-out (LIFO) cost flow starts from the bottom and works its way up. The first units that are assumed to be sold are the newest units with the most recent costs.
Based on the same information given in the FIFO example, the sale of the 7 units on 1/4/2018 must come from the beginning inventory level because it was the only level that existed at that point in time. However, when choosing which costs to use for the sales on 1/22/2018 and 1/28/2018, the most recent costs acquired are now from the purchase on 1/10/2018. Because this is LIFO, which starts from the bottom, the business must begin with the cost at the bottom at the time of the sale. In this example, the purchase that took place on 1/30/2018 is still not relevant because it was made after the sale dates. Therefore, the units in blue will be left in ending inventory. Those units will comprise all 6 units purchased on 1/30/2018 as well as 3 of the units from beginning inventory.

Valuing Inventory Using LIFO Method

LIFO
Summary
Date Description Units Cost Total Cost
Jan. 1 Beginning inventory 7 $1.25 $8.75
Jan. 10 Purchase 5 $1.35 $6.75
Total Cost of Goods $15.50
Jan. 1 Beginning inventory 3 $1.25 $3.75
Jan. 30 Purchase 6 $1.45 $8.70
Remaining Goods (Ending Inventory) $12.45

Similar to the FIFO method, at the end of the period two cost levels remain in ending inventory. Therefore, at the beginning of the next month, inventory contains two levels of costs: 3 units at $1.25 each and 6 units at $1.45 each.

Weighted Average Method of Valuing Inventory

The weighted average method allows the organization to record average inventory costs (cost of goods sold) on the income statement and averaged amounts of inventory on the balance sheet.
In times of rising inventory costs, the weighted average method serves as a middle ground between the FIFO and LIFO methods so that inventory values and cost amounts will fall between FIFO and LIFO values. The illustration for weighted average will be different than FIFO and LIFO methods even though the same information is used. Using the same information, the new cost structure is recalculated after each purchase.

Inventory Information to Calculate Cost

Date Description Units Cost Total Cost
Jan. 1 Beginning inventory 10 $1.25 $12.50
Jan. 4 Sale at $3.00/unit 7
Remaining Units 3 $1.25 $3.75

A new average does not need to be calculated for the first sale. For example, on January 10, Company ABC purchased 5 additional units at $1.35, each creating the need to calculate the average cost. Three units still remain at the $1.25 level.

Weighted Average Cost Calculation

Date Description Units Cost Total
Cost
Jan. 4 Remaining inventory 3 $1.25 $3.75
Jan. 10 Purchased 5 $1.35 $6.75
Total 8 $10.50
Weighted Average Cost = Total Cost ÷ Total Units
Weighted Average Cost = $10.50 ÷ 8 units
Weighted Average Cost = $1.3125

Ideally, the cost will calculate to a round number; however, if it does not, the number should be rounded to four or five digits after the decimal point to ensure the averages are as accurate as possible. Rounding to fewer digits could cause a variation in the amounts because of rounding error. For example, $1.31 per unit, rounded from $1.3125, is used as the weighted average cost per unit. Thus, units sold on 1/22/2018 and 1/28/2018 will cost $1.31 per unit.

Valuing Inventory with Weighted Average Method

Weighted Average Summary
Date Description Units Cost Total
Cost
Jan. 4 Sale from inventory 7 $1.25 $8.75
Jan. 22 Sale at Weighted average 3 $1.31 $3.93
Jan. 28 Sale at Weighted average 2 $1.31 $2.62
Total Cost of Goods $15.30

The next step is to calculate the cost of the remaining items. Remember that after every purchase, the average cost must be recalculated. Therefore, after the 1/30/2018 purchase of 6 units at $1.45 each, the new weighted average cost per unit is $1.40.

Ending Inventory Weighted Average Cost

Date Description Units Cost Total
Cost
Jan. 10 Remaining inventory 3 $1.31 $3.93
Jan. 30 Purchased 6 $1.45 $8.70
Total 9 $12.63
Weighted Average Cost = Total Cost ÷ Total Units
Weighted Average Cost = $12.63 ÷ 9 units
Weighted Average Cost = $1.40

By recalculating the new weighted average cost per unit after the January 30 purchase, the ending inventory is calculated as $12.60, beginning the next month with one level of costs.

Recalculated Weighted Average Cost

Weighted Average
Summary
Date Description Units Cost Total
Cost
Jan. 30 Weighted average after purchase 9 $1.40 $12.60
Remaining Goods (Ending Inventory) $12.60