Accounting: The Language of Business (Part 52)

“There is always something for which there is no accounting. Take, for example, the whole world.” —Unknown

Inventories (Part D)

by

Charles Lamson

Inventory Costing Methods Under a Periodic Inventory System

When the periodic inventory system is used, only revenue is recorded each time a sale is made. No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the merchandise sold.

Like the perpetual inventory system, all cost flow assumption must be made when identical units are acquired at different unit costs during a period. In such cases, the fifo, lifo, or average cost method is used.

First-In, First-Out Method

To illustrate the use of the fifo method in a periodic inventory system, we assume the following data:

The physical count on December 31 shows that 300 units have not been sold. Using the fifo method, the cost of the 700 units sold is determined as follows:

Deducting the cost of merchandise sold of $7,000 from the $10,400 of merchandise available for sale yields $3,400 as the cost of the inventory at December 31. The $3,400 inventory is made up of the most recent costs incurred for this item. Exhibit 5 shows the relationship of the cost of merchandise sold during the year and the inventory at December 31. 

EXHIBIT 5 First-In, First-Out Flow of Costs

Last-In, First-Out Method

When the lifo method is used, the cost of merchandise sold is made up of the most recent costs. Based on the data in the fifo example, the cost of the 700 units of inventory is determined as follows:

Deducting the cost of merchandise sold of $7,600 from the $10,400 of merchandise available for sale yields $2,800 as the cost of the inventory at December 31. The $2,800 inventory is made up of the earliest costs incurred for this item. Exhibit 6 shows the relationship of the cost of merchandise sold during the year and the inventory at December 31.

EXHIBIT 6

Average Cost Method

The average cost method is sometimes called the weighted average method. When this method is used, costs are matched against revenue according to an average of the unit costs of the goods sold. The same weighted average unit costs are used in determining the cost of the merchandise inventory at the end of the period. For businesses in which merchandise sales may be made up of various purchases of identical units, the average method approximates the physical flow of goods.

The weighted average unit cost is determined by dividing the total cost of the units of each item available for sale during the period by the related number of units of that item. Using the same cost data as in the fifo and lifo examples, the average cost of the 1,000 units, $10.40, and the cost of the 700 units, $7,280, are determined as follows:

Average unit cost: $10,400 / 1000 units = $10.40

Cost of merchandise sold: 700 units at $10.40 = $7,280

Deducting the cost of merchandise sold of $7,280 from the $10,400 of merchandise available for sale yields $3,120 as the cost of the inventory at December 31. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 363-365*

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