Introduction
In a periodic inventory system, a company evaluates its finished goods inventory value and cost of goods sold (COGS) at the end of each financial period using various approaches. As noted by Khandelwal (2022), the Periodic Average Cost approach allocates the cost of available goods for sale equally among all items. The First-In, First-Out (FIFO) method presumes that the earliest stock items are the first to be sold.
In contrast, as detailed by Kieso et al. (2020), the Last-In, First-Out (LIFO) method considers that the most recently purchased items are sold initially. Each approach has significant implications for financial reporting, particularly concerning how inventory value and COGS are recorded (Kieso et al., 2020). This document contains an examination of the different methods of valuing inventory, grounded in the annual company data presented below:
Jan. 1 Beginning inventory……… 60 units @ $105 = $6,300
Feb. 8 Purchase……………………… 30 units @ $115 = $3,450
Sept. 11 Purchase…………………… 90 units @ $125 = $11,250
Nov. 23 Purchase…………………… 20 units @ $135 = $2,700
Total available for sale…………… 200 units $23,700Periodic Average Cost
The periodic average cost method is an inventory costing strategy that calculates the cost of goods sold (COGS) and the value of the ending inventory at the close of an accounting period by using the average cost of all comparable items (Khandelwal, 2022). This mean cost is found by dividing the overall cost of goods available for sale by the total amount of available items (Khandelwal, 2022). By applying this method, variations in pricing over the period are evened out, as each inventory unit is assigned the exact average cost (Khandelwal, 2022). The formula to determine the ending inventory with this approach is outlined below:
COGS is the sum of the average cost per unit multiplied by the units sold during the year. Since the total number of units sold is 135 and the average cost per unit is $118.50:
Therefore, under the periodic-average-cost method, the COGS reported on the income statement would be $15,997.5.
FIFO Method
The FIFO (First-In, First-Out) method is an inventory valuation approach in which the earliest-purchased goods are assumed to be the ones sold first; thus, the cost of the older inventory is used to calculate the cost of goods sold (Kimmel et al., 2020). This technique aligns with the natural flow of inventory for many businesses, ensuring that the recorded stock consists of the most recently acquired items (Kimmel et al., 2020). The ending inventory is valued at the cost of the newer goods, potentially leading to a higher book value, particularly in times of rising prices (Kimmel et al., 2020). The ending inventory would include all 20 units bought on November 23 at $135 per unit, along with 45 units acquired on September 11 at $125 per unit. Thus, the ending inventory can be calculated in the following way:
Under FIFO, the oldest stock is sold first, and COGS reflects those older costs. The 135 units sold will consist of 60 units from beginning inventory at $105 each, 30 units from the February 8 purchase at $115 each, and 45 units from the September 11 purchase at $125 each. Thus, COGS under this method would be calculated as follows:
Thus, under the FIFO method, the cost of goods sold recorded on the income statement using the periodic average cost would total $15,375.
LIFO Method
The LIFO approach values inventory by presuming that the items most recently purchased are the first to be sold, thus the older items remain in stock (Kieso et al., 2020). With LIFO, the newest inventory costs are reflected in the cost of goods sold, which could rise during inflationary periods and may lower a business’s taxable income (Kieso et al., 2020). LIFO’s potential to skew reported earnings, coupled with its non-compliance with International Financial Reporting Standards, limits its adoption mainly to firms that report under US Generally Accepted Accounting Principles (Kieso et al., 2020). According to LIFO, the ending inventory would consist of all 60 units purchased on January 1 at $105 per unit and 5 units purchased on February 8 at $115 per unit. Therefore, the ending inventory can be determined as follows:
Under LIFO, the newest stock is considered sold first. The 135 units sold will consist of 20 units purchased on November 23 at $135 each, 90 units purchased on September 11 at $125 each, and 25 units purchased on February 8 at $115 each. Thus, COGS under the LIFO method would be calculated the following way:
Consequently, using the LIFO method, the cost of goods sold reported on the income statement would be $16,825, compared with $16,825 under the periodic average cost method.
Discussion and Conclusion
The choice of an inventory valuation approach can markedly transform the presentation of financial statements. Average Cost moderates price volatility impacts, FIFO could overstate earnings amid inflationary trends, and LIFO might cut tax expenses, albeit possibly at the expense of current cost accuracy. Hence, a company should weigh economic conditions, tax consequences, and profit outcomes when deciding on the optimal method. It’s advisable for the business to regularly reassess its inventory valuation approach in light of changing market dynamics.
References
Khandelwal, R.N. (2022). Cost Accounting According to National Education NEP – 2020. SBPD Publications.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2020). Intermediate Accounting IFRS. John Wiley & Sons.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2020). Accounting: Tools for Business Decision Making. Wiley.