Question

What are the different inventory accounts? What types of costs are factored into a retailer’s inventory accounts and what types of costs are factored into a manufacturer’ inventory accounts?

What factors might influence a company’s management selection of a one inventory cost flow assumption versus another?

Describe the situations in which the gross profit method of estimating inventory would be useful.

What does valuation imply and why is it particularly important to inventory? What special concerns should companies address as they valuate inventory?

Answer 1

Types of Inventory Accounting

Accountants need to determine whether to use first in, first out (FIFO), last in, first out (LIFO), weighted average method, or specific identification method of inventory accounting. If older inventory is less expensive, and you use it first, you would choose the FIFO accounting method. Or, you could assume that you used the most recent, most expensive inventory using the LIFO accounting method.

If FIFO and LIFO will not work for your business for one reason or another, your other options include the weighted average method or the specific identification method. The weighted average method of inventory accounting uses the average cost of your total inventory to assign value to each item used, while the specific identification method involves tracking the cost of each inventory item separately and charging the specific cost of an item to the cost of goods sold.

Continue reading to learn more about each type of inventory accounting.

• FIFO Inventory Accounting Method – When using the FIFO method, accountants assume the items purchased or manufactured first are used or sold first, so the items remaining in stock are the newest ones. The FIFO method aligns with inventory movement in many companies, which makes it a common choice. Prices also rise each year, so accountants who assume the earliest items are the first used can charge the least expensive units to the cost of goods sold first. As a result, the cost of goods trends lower and leads to a higher amount of operation earnings and more taxes to pay. It also means that companies use oldest items first and don’t have to worry about expiration dates or inventory that does not move.
• LIFO Inventory Accounting Method – Accountants who opt for the LIFO method assume items purchased or manufactured last are sold first, so the items remaining in stock are the oldest. As such, this method does notfollow most companies’ natural inventory flow and is banned by International Financial Reporting Standards. When prices rise, the last units purchased are the first used, so the cost of goods trend higher and results in a lower amount of operating earnings and fewer income taxes to pay. Companies using the LIFO method also struggle with obsolete inventory
• Weighted Average Accounting Method – Companies opting for the weighted average method have just one inventory layer. They also roll the cost of new inventory purchases into the cost of existing inventory to determine a new weighted average cost that is readjusted as more inventory is purchased or manufactured.
• Specific Identification Method – The specific identification method requires companies to track the cost of each inventory item separately and charge the specific cost of an item to the cost of goods sold when you sell the specific item. Because this inventory accounting method requires a great deal of data tracking, it is best suited to high-cost items.

Retail Inventory Accounting

Many retailers use projected retail cost to value their inventory. Since there is no work in process --they only have finished goods -- the FIFO, LIFO or weighted-cost methods are somewhat easier to compute. Major retailers, such as Wal-Mart and Target, have massive and diversified inventory items. Pre-computer merchandising posed a challenge for large retailers, as staff-intensive physical counts were necessary at least once per year. Now, sophisticated computer software, constantly updated through POS (point of sale) checkout terminals, keep a perpetual inventory of goods on hand. The formerly complex accounting procedure can be as simple as reading and understanding computer printouts.

The inventory cost flow assumption states that the cost of an inventory item changes from when it is acquired or built and when it is sold. Because of this cost differential, management needs a formal system for assigning costs to inventory as they transition to sellable goods.

For example, ABC International buys a widget on January 1 for $50. On July 1, it buys an identical widget for $70, and on November 1 it buys yet another identical widget for $90. The products are completely interchangeable. On December 1, the company sells one of the widgets. It bought the widgets at three different prices, so what cost should it report for its cost of goods sold? There are a multitude of possible ways to interpret the cost flow assumption

The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other causes.

The gross profit method of estimating ending inventory assumes that we know the gross profit percentage or gross margin ratio. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20 and it has a gross profit percentage or ratio of 20% of the selling price. When this company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 ($50,000 minus 20% of $50,000; or 80% of $50,000).

Let's assume we need to estimate the cost of the July 31 inventory. The last time the merchandise inventory was counted was seven months earlier on December 31 and it had a cost of $15,000. Since December 31, the company purchased merchandise with a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20%. We can estimate the July 31 inventory as follows:

Inventory cost at December 31: $15,000

Purchases between December 31 and July 31 at cost: $42,000

Expected cost of goods available: $57,000 ($15,000 + $42,000)

Cost of goods sold: $50,000 of sales x 80% = $40,000

Estimated Inventory at July 31 at cost: $17,000 ($57,000 - $40,000)