Cost Flow Methods

For a company selling heavy equipment, specific identification would likely make the most sense, as each item would be unique with its own serial number, and these items can be easily tracked. Companies inventory accounting that sell a large number of inexpensive items generally do not track the specific cost of each unit in inventory. Instead, they use one of the other three methods to allocate inventoriable costs.

In addition to the record keeping requirements (and
resulting costs) mentioned above, a major potential problem is the possibility of
„involuntary LIFO liquidation” of inventory. This may result from unexpected
high sales volume at the end of the accounting period. Under this approach an inventory  purchase is made on paper, but
the inventory is not actually delivered. The „seller” agrees to repurchase
the goods at a slightly higher price after the financial statement date.

The Key to Using Inventory Cost Accounting Methods in Your

As there is an increasing emphasis in standard setting on valuation concepts, this approach would result in the most useful information for determining the value of the company. If profitability is more important to a financial-statement reader, then weighted average cost would be more useful, as more current costs would be averaged into income. Companies that use the perpetual system and want to apply the average cost to all units in an inventory account use the moving average method.

Under the perpetual system, the first‐in, first‐out method is applied at the time of sale. The earliest purchases on hand at the time of sale are assumed to be sold. Although the cost of goods available for sale is the same under each cost flow method, each method allocates costs to ending inventory and cost of goods sold differently. Compare the values found for ending inventory and cost of goods sold under the various assumed cost flow methods in the previous examples. Income taxes may also be a consideration when choosing a cost flow formula.

What Is Inventory Costing?

When making an inventory cost flow assumption, what factors do managers need to consider? Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods as much as possible. For example, a grocery retailer selling perishable merchandise may want to use FIFO, as it is common practice to place the oldest items at the front of the rack to encourage their sale first. Alternatively, consider a hardware store that sells bulk nails that are scooped from a bin. There is no way to identify the individual items specifically, and it is likely that over time, customers scooping out nails would mix together items stocked at different times. Weighted average costing would make the most sense in this case, as this would likely represent the real movement of the product.

It would be inappropriate for a company to change cost flow assumptions year to year, simply to achieve a certain result in net income. Once the cost flow assumption is determined, it should be applied the same way each year, unless there has been a significant change in circumstances that warrants a change. A company may use different https://www.bookstime.com/ cost flow assumptions for different major inventory classes, but these choices should still be applied consistently. It is very difficult for managers to manipulate income with this method, as the effects of rising or falling prices will be averaged over both the goods sold and the goods remaining on the balance sheet.