Fifo/Lifo/Average Cost

Who cares?

Well, you should!  It will be on the exam.

Let’s see what is going on.

First, recall cost of goods sold (CGS) impacts the income statement as to the amount of profit generated.

Recall also that inventory is an essential element of that CGS calculation:

Thus: cost of goods available for sale (here shown as \$12,000) – ending inventory = CGS

Also recall that the cost of goods available for sale represents the beginning inventory and all purchases made during the applicable time period.  It is not YET reduced for sales.  In other words, it was the universe of all available items/merchandise that COULD have been sold.

FIFO:

Look at your textbook, page 256, for the basic table shown for FIFO.

Again, recall this chart is telling you the total “universe” of all items in beginning inventory and/or purchased or on hand during the year.  It is not telling you when things were sold.  Notice also the prices were different at various times during the year.

Thus, for ending inventory (given to you in the problem/text) of 450 units, we have to calculate the value.

The book said we had 1000 total units available for sale during the year.  Thus, that means to determine, under FIFO (first in, first out), what the economic cost of the remaining (still unsold) inventory is.

First in first out means the first items received are deemed sold first and we continue until we get to that inventory (physical count) amount (ie., here meaning the inventory starting with the Jan 1 beginning inventory, Apr 15 inventory purchase, etc.

Thus, for ending inventory, we must determine what the financial value is for those 450 units. We start at the last received items, since they are considered retained or still in inventory. We first see 400 units.  We add them to your calculation, and extend their unit cost, or \$13, and get the \$5200.

è Now for the part that confused people.  We have considered 400 out of 450 units remaining in inventory. Where do we get the other 50?

We “take” or calculate them from the next layer up, or the Aug 24 batch of 300 units and also continuing the same direction we went when we started the process (recall we started with the 400 units on Nov 27, or started at the bottom and we are working up).  Thus 400 + 50 is 450.  Notice that the remainder of the Aug 24 batch is now considered to have been sold in the amount of 250 (or 300 -50).

REMEMBER THIS IS NOT NECESSARILY A TRUE ITEM FOR ITEM physical treatment of how the items were sold, this is ONLY an accounting entry.

Thus, to calculate cost of goods sold (CGS) we simply take the total cost of goods available for sale (the \$12,000) [recall this is the total available inventory that could be sold when you add in the beginning inventory and ALL purchases during the time period] and subtract the ending inventory of \$5800 and get the CGS of \$6200.

And we can prove this calculation.  It’s a little work, but to prove this, we simply add up and extend the items that are considered sold from the listing we have, or

100                                    10              1000

200                             11              2200

250              12              3000

550                              6,200

Recall 550 units were considered sold.  THUS, First in, first out, means we sold the oldest first, while the newest received purchases/inventory is considered to remain in inventory.

LIFO

The same approach is taken for LIFO.  See the same assumptions on Cost of goods available for sale, see page 257.

Here, however, we consider the oldest items to be sold LAST, while the newest items are considered sold first. Thus, for ending inventory, we consider the oldest items in our universe of items available for sale to be STILL IN THE INVENTORY (Dollar value wise).

Thus, for our ending inventory of 450, we go to the oldest items first, or the beginning inventory of 100 @ 10, but we still need 350, so we next go to the next layer of 200 @11, but, we don’t have “enough” here, so we have to go to the next and successive layers, if necessary.  Thus, to get the remaining 150 (450-300), we take them from the Aug 24 layer of purchases.

Thus, the end result is ending inventory, when you “extend” it all out, of \$5000. See the text.

The Cost of goods sold is simply \$12,000 less the ending inventory of \$5000, or \$7000.

You proved your CGS calculation by calculating the amount sold, by going from the newest back, or 400 @13 + 150 @12= 7000.

In other words, it is the reverse of what you did before, because under LIFO, the last (i.e., the newest) inventory you bought is considered to be sold first, while under FIFO, the oldest inventory/purchases you bought/had is considered sold first.

AVERAGE COST

The compromise and most logical at times is the average cost computation.

Here you simply take a mathematic average of the cost of all the items you have purchased and then extend it by the ending inventory.

Here, we had 1,000 total items available which cost a total of \$12,000.

12,000/1000= average unit cost of \$12

Ending inventory= 450 * 12= \$5400

CGS= 12,000-5,400 or 6,600

Proof:  550 sold items * 12= 6,600.

Now, look over the chart on page 260 and notice the impact on the gross profit between the three methods and read carefully the materials in book!