When accounting for cost of goods sold, there are several means by which inventory pricing is determined. In maintaining and growing a company, inventory is often bought and sold at different prices instead of at a lump amount. At the end of an accounting period when purchased and sold items are calculated, there are several means by which these products may be valued.
Before assigning costs to products, the correct method of accounting inventory for your business must be determined. In a prior article, we detailed the periodic and perpetual methods, which can be used with these methods. After utilizing one of these methods, the total costs and units sold and on hand must be calculated.
The first method is specific identification, where goods are counted at the end of an accounting year to determine how many goods purchased throughout the year still remain. After the goods are totaled, this amount is multiplied by the original purchase cost to arrive at the final inventory cost. This method is the simplest, as specific costs are matched with goods. However, this method can be abused. If cheaper items are reported as sold first, the ending inventory cost will be higher and the cost of goods sold will be lower, artificially increasing income. This could result in lower, unearned taxes. This method can also be difficult when calculating large volumes of goods sold. Matching all sold items with the exact cost can be extremely difficult if handling many items of a similar nature, such as food items. On the other hand, sellers of high-price, low-volume items such as luxury vehicles and jewelry have easier access to invoices.
The second method of cost flow is first-in, first-out, or FIFO. This method states that cost is matched with revenue in chronological order. Therefore, whenever a sale occurs, the oldest inventories created by the company are marked as sold first, even if this is not the case. Costs may change over the course of an accounting period, affecting the ending inventory. For example, consider that a shipment of 10 items is sold for $10 each and the next shipment of 15 items is sold for $15 each. If 7 items out of 25 are left at the end of an accounting period, it is assumed that the 10 items sold for $10 have all been sold first, even though this may not be the case.
The third method of cost flow is last-in, first-out, or LIFO. This method states that cost is matched with revenue in reverse order. Whenever a sale occurs, the newest inventories created by a business are marked as sold first, even if this is not the case. Using the example above, if 7 items were left at the end of an accounting period, it would be assumed that the shipment of $15 items would be completely sold first, resulting in a smaller ending inventory amount. LIFO is often conducted to artificially reduce the level of income, reducing income taxes. If LIFO is used for taxes, it must also be used for financial reporting within the same period. Though LIFO is allowed within the United States, the practice is banned by the International Financial Reporting Standards.
The average cost method determines inventory costing by creating an average cost for an accounting period. This is found by dividing total costs of available goods by total units available at the beginning of a period. This method is simple because detailed cash inflows and outflows are not analyzed, as is common with the other methods. Each item sold is assumed to have the same cost and no attention is given to when the product was sold. Ending inventory is also assumed to have the same cost.