Inventory Expense Recognition

Inventory refers to the short-term assets on a company’s balance sheet; example – a retail clothier’s stock of shirts, pants, etc. 

The expense for inventory is a part of the cost of goods sold. The flow of inventory costs into the accounting system is determined based on the inventory accounting policy, not the physical flow of goods.

The commonly used methods are:

• Specific cost identification
• First-in, first-out (FIFO)
• Last-in, first-out (LIFO)
• Average cost

Specific Cost Identification

This method is used when the company can identify exactly which items were sold and which ones are still in the inventory. For example, a laptop dealer sells his inventory of laptops based on their serial number.

FIFO

First-in, first-out accounting method, where the costs of the oldest items in inventory are used to compute the cost of goods sold (COGS) expense on a company’s income statement.

FIFO ending inventory for the balance sheet is calculated based on values of the most recent inventory goods purchased.

LIFO

Last-in, first-out accounting method, where the costs of the newest inventory items are used to compute the COGS expense on the income statement.

LIFO ending inventory for the balance sheet is calculated based on values of the first inventory goods purchased.

Average Cost

Under the weighted average cost method, average cost is calculated by dividing the total cost of available goods with the no. of units available. The average cost is used to determine both the cost of goods sold and the ending inventory.

In some instances, the choice of LIFO or FIFO makes intuitive sense for a specific company.  A farmer’s market shop would conceptually be a FIFO business, as the oldest produce should be sold first, given that it will spoil the soonest compared to younger produce.

In reality a company’s management is usually allowed some degree of flexibility in determining its inventory accounting method.  If an analyst is comparing firms in a shared industry structure or market capitalization size, then differences in inventory accounting methods need to be reconciled through the financial statement adjustment process, so the analyst can be sure that the financial ratios for the firms are truly comparable.

The US GAAP permits the use of FIFO, LIFO as well as average cost method.

IFRS allows FIFO and average cost but prohibits LIFO method.

COGS Expense Calculation

Beginning Inventory (BI) + Purchases = Goods Available for Sale (GAS)

GAS – Ending Inventory (EI) = COGS

COGS is used in calculating a company’s gross profit and gross profit margin (the decimal is typically converted to a percentage)

Gross Profit = Net Revenue – COGS

Example

A company’s inventory data during a month are shown in the table below:

During the month the company sold, 17 units. 

Let’s calculate the cost of goods sold and ending inventory under different methods.

First-in, First-out (FIFO)

Total 17 units are sold. The earlier units are sold first.

Last-in, First-out (FIFO)

Total 17 units are sold. The recently purchased units are sold first.

Average Cost

Average cost per unit = 2250/20 = $112.5

Cost of goods sold = 112.5*17 = $1,912.5

Ending Inventory = 112.5*3 = $337.5