Lesson 1 of 8 · All lessons in this module
- Inventory cost formulas and inventory systemsVideo lesson
- Rising and falling costs: effects on statements and ratiosVideo lesson
- The LIFO reserve, LIFO-to-FIFO conversion and LIFO liquidationVideo lesson
- Measuring inventory: lower of cost and net realisable valueVideo lesson
- Inventory write-downs: effects on ratios and analysis
- Inventory disclosures, ratios and analyst checks
- Integrated cases: reading the inventory note and restating to one basis
- Integrated cases: a two-year ratio panel and 'what if the cost formula changed'
Free lesson: the first lesson of every module is open to everyone.
Lesson 1 of 8 · 13 min
Inventory cost formulas and inventory systems
Every cost formula splits the same cost of goods available for sale between cost of sales and ending inventory; the formulas only disagree about which units are assumed to be sold.
In short
- Cost of goods available for sale = beginning inventory + purchases. It ends up either in cost of sales (income statement) or in ending inventory (balance sheet).
- FIFO sells the oldest units first; LIFO sells the newest first; weighted average cost gives every unit the same average cost; specific identification tracks the actual units.
- IFRS allows FIFO, weighted average and specific identification. LIFO is permitted only under US GAAP.
- A periodic system works out cost of sales at period-end; a perpetual system updates inventory with every sale. The two can give different LIFO (and weighted average) results, but FIFO and specific identification give the same answer either way.
- Inventory cost includes purchase costs (including non-recoverable taxes and duties), conversion costs and costs needed to bring goods to their present location and condition; storing finished goods that await shipment is not included.
One pool of cost, two destinations
Start with everything a company could have sold this period: the inventory it began with plus what it bought or made. That total is the cost of goods available for sale. By the end of the period, every unit of that cost has gone to one of two places.
Units that were sold go to cost of sales (cost of goods sold, COGS) on the income statement. Units still on the shelf stay in ending inventory on the balance sheet. The identity beginning inventory + purchases − ending inventory = cost of sales always holds.
When purchase prices never change, it does not matter which units count as sold. Once prices move, the choice of cost formula (also called the inventory valuation method or cost flow assumption) decides how much of the total lands in each place, and so changes gross profit, net income, current assets and total assets.
The four cost formulas
The physical flow of goods does not have to match the cost formula. A grocer sells the oldest milk first, but it could still account for its costs as if the newest cartons were sold. The formula is an accounting assumption, chosen as a policy and disclosed in the notes.
- Specific identification suits items that are not interchangeable, such as custom-built goods or high-value unique items.
- Weighted average cost puts the same per-unit cost in both cost of sales and ending inventory.
- FIFO leaves the latest purchases in inventory, so the balance sheet figure is close to current replacement cost.
- LIFO charges the latest purchases to cost of sales, so cost of sales is close to current replacement cost while the balance sheet keeps old, often stale, costs.
| Formula | Assumed sold first | Ending inventory reflects | IFRS | US GAAP |
|---|---|---|---|---|
| FIFO (first-in, first-out) | Oldest units | Most recent costs | Yes | Yes |
| Weighted average cost | Every unit at the same average cost | Average cost | Yes | Yes |
| Specific identification | The actual units sold | Actual cost of units on hand | Yes | Yes |
| LIFO (last-in, first-out) | Newest units | Oldest costs (old 'layers') | No | Yes |
Because LIFO is banned under IFRS, comparing a US GAAP LIFO company with an IFRS peer needs an adjustment first. The LIFO reserve lesson shows how.
Periodic versus perpetual systems
In a periodic system the company counts inventory at period-end and backs into cost of sales: goods available minus what is left. The cost formula is applied once, to the whole period's purchases.
In a perpetual system the inventory record is updated every time a unit is bought or sold, so the formula is applied sale by sale, using only the units on hand at that moment.
Under FIFO the oldest units go first either way, so the result is identical. Specific identification tracks real units, so it is identical too. Under LIFO the answer usually differs: a periodic system can assign a December purchase to a March sale, whereas a perpetual system cannot, and it may dip into older layers during the year. Weighted average results can differ as well, because a perpetual system recomputes the average after each purchase.
What goes into the cost of inventory
Inventory is carried at the costs needed to get it ready to sell where it is. That includes the purchase price plus import duties and other non-recoverable taxes, transport in, and the conversion costs of a manufacturer, including storage that is a necessary part of the production process (for example, ageing a product between production stages).
Costs that arise after the goods are ready are expensed, not capitalised. Storing finished goods while they wait to be shipped to customers, selling costs, administrative overheads and research and development do not belong in inventory.
Formulas
- Cost of goods available for sale
The total that the cost formula splits between cost of sales and ending inventory.
- Cost of sales
Holds under every cost formula. A higher ending inventory means a lower cost of sales, and vice versa.
- Weighted average unit cost (periodic)
Applied to both units sold and units on hand.
Worked examples
Example 1 Three formulas, one set of purchases
Ridgeway Outfitters Inc. (US GAAP, periodic system) starts the year with 200 tents at USD 10. It buys 300 at USD 12 and then 500 at USD 13. It sells 700 tents at USD 20 each. Find cost of sales, ending inventory and gross profit under FIFO, weighted average cost and LIFO.
Example 2 Periodic versus perpetual LIFO
Brookfield Supply Co. (US GAAP) begins with 100 units at USD 20. In January it buys 100 at USD 22; in March it sells 150; in June it buys 100 at USD 25; in September it sells 80. Compare LIFO cost of sales and ending inventory under a periodic and a perpetual system, then check FIFO.
On the exam
Expect a short table of purchases and sales with a question on cost of sales or ending inventory under one formula, plus concept items: which formula IFRS bans, which formula is affected by periodic vs perpetual, and which costs belong in inventory.
- Thinking LIFO is allowed under IFRS. It is a US GAAP option only.
- Assuming the choice of periodic or perpetual system changes FIFO results. It changes LIFO (and possibly weighted average), not FIFO or specific identification.
- Using a simple average of purchase prices instead of the unit-weighted average.
- Capitalising storage of finished goods waiting for shipment; it is an expense of the period.
Check yourself
Q1A company starts with 400 units at USD 5 and buys 600 units at USD 6. It sells 700 units. Using periodic FIFO, cost of sales is closest to:
Q2Using the same data (400 units at USD 5, then 600 at USD 6, 700 sold), ending inventory under the weighted average cost method is closest to:
Q3Which inventory cost formula is permitted under US GAAP but not under IFRS?
Q4Whether a company uses a periodic or a perpetual inventory system is most likely to change reported inventory under:
Q5Which cost is least likely to be included in the carrying amount of a manufacturer's inventory?
Q6Which cost formula gives an ending inventory figure that most closely reflects current replacement cost when prices are changing?
Answer the 6 questions: +10 XP for each one you get right first time.
Liked this lesson? Get the rest free for 7 days
Create a free account to open the other 7 lessons in this module, with videos, flashcards that come back before you forget them, the question bank and full mocks. No card needed.