Accounting: The Language of Business - Vol. 2 (Intermediate: Part 161)

1 Corinthians 16:2

On the first day of every week, each of you is to put something aside and store it up, as he may prosper, so that there will be no collecting when I come.

 Short-Term Operating Assets: Inventory (Part G)

by

Charles Lamson

Inventory Allocation Methods

There are four common methods to allocate the cost of goods available for sale between ending inventory (the value of a company's inventory that is still available for sale at the end of an accounting period) and cost of goods sold (the total cost a business incurs to produce and sell its goods):

1. Specific identification method: The company identifies each unit and tracks the cost associated with that specific unit.

2. Moving average method: The company determines an average cost for the units on hand and applies that average unit cost to the next sale to determine the cost of goods sold.

3. First-in, first-out (FIFO) method: The company assigns the most recent cost to ending inventory and the oldest cost to cost of goods sold.

4. Last-in, first out (LIFO) method: The company assigns the oldest costs to ending inventory and the most recent cost to cost of goods sold.

It is important to note that a company does not have to sell its inventory in a pattern that resembles its accounting assumptions. For example, a grocery store is likely to sell gallons of older milk first. Yet, it could choose to use a moving average cost to determine the cost of goods sold because it is easier to implement. We will examine the four methods in depth using a common example to compare and contrast the financial reporting effects.

Each of two other approaches to inventory allocation---the retail inventory method and gross profit method--approximate the ending inventory balance reported. We discuss the retail inventory method and the gross profit method in a later post.

Specific Identification Method

With the specific identification method, a company identifies each unit and tracks its actual cost, as illustrated in Example 10.6. This approach is suitable for companies that sell high-dollar products with low sales volume. For example, a truck dealer can identify a vehicle that was available for sale by referencing its vehicle identification number and determining whether it was sold or is still in ending inventory. The method is impractical, however, for most companies. Imagine a grocery wholesaler using specific identification on each of the products it sells. 

*GORDON, RAEDY, SANNELLA, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 518-519*

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