Accounting: The Language of Business - Vol. 2 (Intermediate: Part 160)

Proverbs 11:28

"Whoever trusts in his riches will fall, but the righteous will flourish like a green leaf".

1 Corinthians 4:2

Moreover, it is required of stewards that they be found faithful.

Short-Term Operating Assets: Inventory (Part F)

by

Charles Lamson

 

*Accounting: The Language of Business - Vol. 2 (Intermediate: Part 159)

Inventory Cost-Flow Assumption

A company usually does not track each individual item of inventory in its accounting system as the item is purchased and eventually sold. Rather, a company will choose a cost-flow assumption to move the cost of the item from inventory to cost of goods sold in the accounting system.

Consider a store that buys sweaters in different sizes and colors during the year. The cost of each type of sweater varies slightly depending on when it was purchased. If the same store does not track each individual sweater, how does the store determine the cost of the sweaters sold and the cost of the sweaters remaining in the store? If the cost of each sweater were always the same, the store would simply multiply the number of sweaters sold and the number of sweaters remaining in ending inventory by the constant cost to determine the cost of goods sold in ending inventory, respectively. But a constant cost is unlikely to occur in practice. Thus, the store must determine which of the sweaters available for sale were sold and which remain in the store.

To make the allocation, the store first determines the cost of the goods that it has available for sale as illustrated in Example 10.5.

Example 10.5 illustrates that allocation complexities result from varying inventory acquisition costs. Cowboy Accessories Enterprises has a total cost of $35,850. Allocating the $35,850 cost of goods available for sale between cost of goods sold and ending inventory depends on which hats were sold and which hats remain in inventory. Exhibit 10.4 depicts this allocation issue. Beginning inventory of $20,000 and purchases of $15,850 contribute to cost of goods available for $35,850. Cowboy Accessories must allocate the amount between cost of goods sold and ending inventory. That is, it needs to determine the portion of the $35,850 to include in ending inventory on the balance sheet and how much of the cost of goods available for sale to report as cost of goods sold on the income statement.

If the cost of hats is constant over time or if Cowboy Accessories can specifically identify the exact cost of the units sold, the allocation is straightforward. However, prices are seldom constant overtime, and it is not always practical to specifically identify each unit. It is the cost of changing prices, in the case of changing prices, firms usually make cost-flow assumptions. Specifically, rather than tracking the cost of each hat purchased and sold, Cowboy can use cost flow assumptions to allocate the $35,850 total cost of goods available for sale to the 400 hats in ending inventory and the 1,250 hats sold. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 516-517*

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