The specific identification costing assumption tracks inventory items individually, so that when they are sold, the exact cost of the item is used to offset the revenue from the sale. The cost of goods sold, inventory, and gross margin shown in Figure 10.5 were determined from the previously-stated data, particular to specific identification costing. The LIFO costing assumption tracks inventory items based on lots of goods that are tracked in the order that they were acquired, so that when they are sold, the latest acquired items are used to offset the revenue from the sale. The following cost of goods sold, inventory, and gross margin were determined from the previously-stated data, particular to perpetual, LIFO costing.

1. Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times.
2. By offsetting sales income with their highest purchase prices, they produce less taxable income on paper.
3. Thus, after two sales, there remained 10 units of inventory that had cost the company $21, and 65 units that had cost the company $27 each.
4. That is, it is used primarily by businesses that must maintain large and costly inventories, and it is useful only when inflation is rapidly pushing up their costs.
5. This means that at the beginning of February, they had 50 units in inventory at a total cost of $350 (50 × $7).

Let’s return to The Spy Who Loves You Corporation data to demonstrate the four cost allocation methods, assuming inventory is updated on an ongoing basis in a perpetual system. LIFO is banned under the International Financial Reporting Standards that are used by most of the world because it minimizes taxable income. That only occurs when inflation is a factor, but governments still don’t like it.

Ending inventory was made up of 10 units at $21 each, 65 units at $27 each, and 210 units at $33 each, for a total specific identification ending inventory value of $8,895. Subtracting this ending inventory from the $16,155 total of goods available for sale leaves $7,260 in cost of goods sold this period. The specific identification method requires a business to identify each unit of merchandise with the unit’s cost and retain that identification until the inventory is sold. Once a specific inventory item is sold, the cost of the unit is assigned to cost of goods sold.

Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e.g., automobiles, fine jewelry, and so forth). As you can see, the inventory method a company uses affects its cost of goods sold, which impacts profitability. If you use the FIFO method, you’ll report a lower COGS, which increases your gross profit and net income. This method’s biggest issue is that it leaves a grossly understated ending inventory balance that only gets more egregious as time goes on. Basically, unless you are turning over 100% of your inventory before buying more, the first items bought never actually show as sold. Over time, as prices rise, these ending inventory balances become less and less representative of the actual value of that inventory.

For More Mature Businesses

Subtracting this ending inventory from the $16,155 total of goods available for sale leaves $7,200 in cost of goods sold this period. Once the unit cost of inventory is determined via the preceding logic, specific costing methods must be adopted. In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold).

Most computer systems will show you the Inventory Record form so you need to understand how to read it. However, it can be time consuming and not practical for homework and test situations so you learn the alternative method as well. We will be using the perpetual inventory system in these examples which constantly updates the inventory account balance to reflect inventory on https://accounting-services.net/ hand. The first step is to figure out how many items were included in COGS and how many are still in inventory at the end of August. ABC company had 200 items on 7/31, which is the ending inventory count for July as well as the beginning inventory count for August. As of 8/31, ABC Company completed another count and determined they now have 300 items in ending inventory.

Inventory Costing Methods Pros, Cons, and How to Choose One for Your eCommerce Business

Although the physical number of units in ending inventory is the same under any method, the dollar value of ending inventory is affected by the inventory valuation method chosen by management. For The Spy Who Loves You, considering the entire period together, 300 of the 585 units available for the period were sold, and if the latest acquisitions are considered sold first, then the units that remain under LIFO are those that were purchased first. Following that logic, ending inventory included 150 units purchased at $21 and 135 units purchased at $27 each, for a total LIFO periodic ending inventory value of $6,795. Subtracting this ending inventory from the $16,155 total of goods available for sale leaves $9,360 in cost of goods sold this period. For The Spy Who Loves You, considering the entire period, 300 of the 585 units available for the period were sold, and if the earliest acquisitions are considered sold first, then the units that remain under FIFO are those that were purchased last. Following that logic, ending inventory included 210 units purchased at $33 and 75 units purchased at $27 each, for a total FIFO periodic ending inventory value of $8,955.

With the Periodic Inventory System, inventory and cost of goods sold accounts are updated periodically. With a Perpetual Inventory System, inventory and cost of goods sold accounts are updated with each sale, or perpetually. So, why do so many businesses neglect inventory and fail to establish a method for valuing one of their biggest assets & expenses? Inventory management can be intimidating, and is made more so due to the multiple approaches you can take. This is because calculating profit from stock is more straightforward, meaning your financial statements are easy to update, as well as saving both time and money. It also means that old stock does not get re-counted or left for so long it becomes unusable.

FIFO, LIFO, and WAC Example

During a period of rising prices or inflationary pressures, FIFO (first in, first out) generates a higher ending inventory valuation than LIFO (last in, first out). Inventory may also need to be written down for various reasons including theft, market value decreases, and general obsolescence in addition to calculating ending inventory under typical business conditions. Inventory market value may decrease if there is a large dip in consumer demand for the product. Similarly, obsolescence may occur if a newer version of the same product is released while there are still items of the current version in inventory. This type of situation would be most common in the ever-changing technology industry. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income.

Next thing to remember, you can only use items that occurred BEFORE the sale (meaning, you cannot use a purchase from August 28 when calculating cost of goods sold on August 14 – why? It hasn’t happened yet). We will the inventory costing method that reports the earliest costs in ending inventory is pick inventory from the different purchases and use the purchase price to calculate the cost of goods sold. There are a couple of ways you can do them – there is an Inventory Record or a shortcut calculation.

The FIFO costing assumption tracks inventory items based on lots of goods that are tracked, in the order that they were acquired, so that when they are sold the earliest acquired items are used to offset the revenue from the sale. The cost of goods sold, inventory, and gross margin shown in Figure 10.15 were determined from the previously-stated data, particular to perpetual FIFO costing. The specific identification costing assumption tracks inventory items individually so that, when they are sold, the exact cost of the item is used to offset the revenue from the sale. The cost of goods sold, inventory, and gross margin shown in Figure 10.13 were determined from the previously-stated data, particular to specific identification costing. The LIFO costing assumption tracks inventory items based on lots of goods that are tracked, in the order that they were acquired, so that when they are sold, the latest acquired items are used to offset the revenue from the sale. The following cost of goods sold, inventory, and gross margin were determined from the previously-stated data, particular to LIFO costing.

The outcomes for gross margin, under each of these different cost assumptions, is summarized in Figure 10.21. In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income. This is why LIFO creates higher costs and lowers net income in times of inflation. In contrast, using the FIFO method, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200.

Those using a perpetual inventory system will assign a value to their inventory with each sale. Raw materials are those used in the primary production process or materials that are ready to be manufactured into completed goods. The second, called work-in-process, refers to materials that are in the process of being converted into final goods. These goods have gone through the production process and are ready to be sold to consumers.