Accounting: The Language of Business (Part 51)

“And he read Principles of Accounting all morning, but just to make it interesting, he put lots of dragons in it.” —Terry Pratchett

Inventories (Part C)

by

Charles Lamson

Inventory Costing Methods Under a Perpetual Inventory System

In a perpetual inventory system, as we discussed in a previous post, all merchandise increases and decreases are recorded in a manner similar to recording increases and decreases in cash. The merchandise inventory account at the beginning of an accounting period indicates the merchandise in stock on that date. Purchases are recorded by debiting Merchandise Inventory and crediting Cash or Accounts Payable. On the date of each sale, the cost of the merchandise sold is recorded by debiting cost of merchandise sold and crediting merchandise inventory.

As we illustrated in part 50, when identical units of an item are purchased at different unit costs during a period, a cost flow must be assumed. In such cases, the first-in, first-out (fifo), last-in, last-out (lifo), or average cost method is used. We illustrate each of these methods, using the data for item 127B, shown below.

First-In, First-Out Method

Most businesses dispose of goods in the order in which the goods are purchased. This would be especially true of perishables and goods whose styles or models often change. For example, grocery stores shelve their milk products by expiration dates. Likewise, men's and women's clothing stores display clothes by season. At the end of the season, they often have sales to clear their stores of off-season or out-of-style clothing. Thus, the fifo method is often consistent with the physical flow or movement of merchandise. To the extent that this is the case, the fifo method provides results that are about the same as those obtained by identifying the specific costs of each item sold and in inventory. 

When the fifo method of costing inventory is used, costs are included in the cost of merchandise sold in the order in which they were incurred. To illustrate, Exhibit 3 shows the journal entries for purchases and sales and the inventory subsidiary ledger account for Item 127B. The number of units in inventory after each transaction, together with total costs and unit costs, are shown in the account. We assume that the units are sold for $30 each on account.

EXHIBIT 3 Entries and Perpetual Inventory Account (Fifo)

You should note that after the 7 units were sold on January 4, there was an inventory of 3 units at $20 each. The eight units purchased on January 10 were acquired at a unit cost of $21, instead of $20. Therefore, the inventory after the January 10 purchase is reported on two lines, 3 units at $20 each and 8 units at $21 each. Next, note that the $81 cost of the four units sold on January 22 is made up of the remaining three units at $20 each and one unit at $21. At this point, 7 units are in inventory at a cost of $21 per unit. The remainder of the illustration is explained in a similar manner.

Last-In, First-Out Method

When the lifo method is used in a perpetual inventory system, the cost of the units sold is the cost of the most recent purchases. To illustrate, Exhibit 4 shows the journal entries for purchases and sales and the subsidiary ledger account for item 127B, prepared on a lifo basis. 

EXHIBIT 4 Entries and Perpetual Inventory Account (Lifo)

If you compare the ledger accounts for the fifo perpetual system and the lifo perpetual system, you should discover that the accounts are the same through the January 10 purchase using lifo, however, the cost of the four units sold on January 22 is the cost of the units from the January 10 purchase ($21 per unit). The cost of the seven units in inventory after the sale on January 22 is the cost of the three units remaining from the beginning inventory and the cost of the four units remaining from the January 10 purchase. The remainder of the lifo illustration is explained in a similar manner.

When the lifo method is used, the inventory ledger is sometimes maintained in units only. The units are converted to dollars when the financial statements are prepared at the end of the period.

The use of the lifo method was originally limited to rare situations in which the units sold were taken from the most recently acquired goods. For tax reasons, which we will discuss later, its use has greatly increased during the past few decades. Lifo is now often used even when it does not represent the physical flow of goods.

Average Cost Method

When the average cost method is used in a perpetual inventory system, an average unit cost for each type of item is computed each time a purchase is made. This unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average. Since the average cost method is rarely used in a perpetual inventory system, we do not Illustrate it in this post.

Computerized Perpetual Inventory Systems

The records for a perpetual inventory system may be maintained manually. However, such a system is costly and time-consuming for businesses with a large number of inventory items with many purchase and sales transactions. In most cases, the record-keeping for perpetual inventory systems is computerized.

An example of using computers and maintaining professional inventory records for retail stores follows.

1. The relevant details for each inventory item, such as a description, quantity, and unit size, are stored in an inventory record. The individual inventory records make up the computerized inventory file, the total of which agrees with the balance of the inventory ledger account.

2.  Each time an item is purchased or returned by a customer, the inventory data are entered into the computer's inventory records and files.

3.  Each time an item is sold, a salesclerk scans the item's bar code with an optical scanner. The scanner reads the magnetic code and it rings up the sale on the cash register. The inventory records and files are then updated for the cost of goods sold.

4.  After a physical inventory is taken, the inventory count data are entered into the computer. These data are compared with the current balances, and a listing of the coverages and shortages is printed. The inventory balances are then adjusted to the quantities determined by the physical count.

Such systems can be extended to aid managers in controlling and managing inventory quantities. For example, items that are selling fast can be reordered before the stock is depleted. Past sales patterns can be analyzed to determine when to mark down merchandise for sales and when to restock seasonal merchandise. In addition, such systems can provide managers with data for developing and fine-tuning their marketing strategies. For example, such data can be used to evaluate the effectiveness of advertising campaigns and sales promotions. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 360-363*

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