It assumes that the first product in is the first product to be sold. WAC is perhaps the most intuitive and simple inventory valuation method. Using this method, a company simply determines the average cost of their inventory orders. However, while potentially simpler, WAC does not always accurately reflect the value of inventory, depending on the business model and product volume.
In the case of similar products at similar price points at a time of relatively stagnant pricing, the WAC method can be relatively reliable. Choosing the appropriate inventory valuation method for your business will depend on a variety of factors such as your business model, your product type and volume, and any applicable accounting laws.
LIFO is rarely used; often the only benefit is the potential to lower the tax bracket of a large business by underestimating the value of the stock when prices are rising. The FIFO method is commonly used, due to its accurate reflection of the ending value of inventory and its compliance with most inventory reporting laws and guidelines. It is especially useful for businesses with highly perishable inventory, like an ice cream company , in which case the oldest products need to be sold first.
All this information helps companies decide the needed margins to assign to each product or product type. Industry expert Steven J. Weil, Ph. He says,. Setting similar margins in each department is easier to track. These similar margins show us when there is shrinkage and how much that product is bringing in and what it could be bringing in.
In accounting, the difference in cost of goods sold COGS and inventory values are represented by where the accountant records them. Companies value inventory at its cost to them and as a part of their current assets. COGS represents the inventory costs of goods sold to customers. Accountants record the ending inventory balance as a current asset on the balance sheet. When inventory increases, the assets on the balance sheet increase. When inventory decreases, the assets on the balance sheet also decrease.
Accountants also record the change in inventory as a part of the COGS on the income statement. Companies generally report inventory value at their paid cost. However, a manufacturer would report inventory at the cost to produce the item, including the costs of raw materials, labour and overhead. The method companies use to cost their inventory directly guides the income and inventory value they report on their financial statements.
Each company chooses a systematic approach to calculating and reporting its inventory turnover, and regulators expect them to stick to that method every year. Regardless of which cost flow assumption the company uses, the balance sheet for the period starts the same. This journal shows the same beginning inventory, purchase and associated costs:. However, when a customer buys 60 units, the difference in these cost flow assumptions is clear.
In FIFO, the ending inventory cost ends up higher to reflect the increase in prices. As a comparison, in LIFO, the ending inventory cost is lower as a reflection of the increasing prices of the bookcase. As noted, specific identification is not technically a cost flow assumption, but it is a technique for costing inventory.
In this case, the physical flow of inventory matches the method and is not reliant on timing for cost determination. The use of serial numbers or identification tags accommodate the use of this method and the identification of each item in inventory, capturing when the company bought the item and how much it paid. Consider an art dealer that specialises in only one product type, handmade globes. An example of his inventory flow follows:.
From this information and the information about which specific products the dealer sold over the period, he can calculate the following figures:.
Ending inventory and COGS are based on what the dealer sold or did not sell from each specifically identified purchase or beginning inventory. Notice how he separated each purchase based on what he originally paid for them. He knows that customers purchase his handmade items based on which specific ones they prefer, not on the lot he bought them in.
The gross profit is period retail sales minus the total spent originally for the specific goods he sold during the period. The HIFO example removes the highest cost inventory first, leaving less value in stock, and the LOFO example removes the lowest cost inventory first, leaving a higher value in stock. In FEFO, expiration dates drive the sales. For example, if a retailer began with and purchased a total of 80 units and sold 40 units with two different expiration dates, it would look like the following:.
The items in stock after the sale have a later expiration date. The company exhausts the stock with the earliest expiration date first. GAAP allows adjustments in inventory valuation when it has an uncertain future, such as when it may become obsolete. Methods for these adjustments include:. The weighted average inventory costing method, also called the average cost inventory method, is one of the GAAP-compliant approaches companies use to value their business stock. This method calculates the per-unit cost using a weighted average for the cost of goods sold and the inventory.
The formula for the weighted average cost method is a per unit calculation. Divide the total cost of goods available for sale by the units available for each inventory item. For example, Trax is a small business that purchases and sells snowboards. For November, the following shows its purchases and sales:. The ending inventory is the total units available minus the total units sold during the period. Calculate the weighted average cost for the snowboards by using the following chart that shows the number of units purchased, the cost for each unit on the date purchased and the total cost paid for the purchase on that day.
The cost of goods sold COGS valuation is the number of units sold multiplied by the weighted average cost. The ending inventory valuation is the units remaining multiplied by the weighted average cost.
Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost e. To illustrate, assume Classic Cars began the year with 5 units in stock. Classic has a detailed list, by serial number, of each car and its cost. Each car is unique and had a different unit cost. The year ended with only 3 cars in inventory.
Under specific identification, it would be necessary to examine the 3 cars, determine their serial numbers, and find the exact cost for each of those units. The cost of goods sold could be verified by summing up the individual cost for each unit sold. Necessary cookies are absolutely essential for the website to function properly. These cookies ensure basic functionalities and security features of the website, anonymously.
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Home Chapter 8: Inventory. Did you learn? Understand cost of goods available for sale, and how this cost must be allocated to inventory and cost of goods sold. Distinguish between the physical flow of goods and their cost flow for accounting purposes.
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