Given equal circumstances, which inventory method would probably be the most time-consuming?

One sure-fire way to determine exactly what your business has in its inventory is to go in and count every single item. However, taking a physical inventory isn't always practical or even possible, so a business needs a reliable way of estimating the value of its inventory. Two of the most common methods for doing that are the gross profit method and the retail inventory method.

Purpose

1. Taking a physical inventory is necessary, but it's also time-consuming and expensive. You may have to close your business for a day or part of a day to "freeze" the inventory for counting, or you may have to pay employees overtime to come in during non-business hours to conduct the count. These considerations limit how often you can perform a physical inventory. However, between these "hand-counts," you still need information to plan your budget and prepare financial reports. In some cases, such as after a fire or robbery, a physical inventory is impossible because the items are gone, but you still must be able to estimate the value of the lost inventory to put in an insurance claim or deduct the loss on your taxes. In situations like these estimation methods come into play.

Choosing a Method

1. Each method depends on knowing the difference between how much it costs you to obtain or produce the items you sell and the price at which you sell them to customers.

   The gross profit method uses your company's current profit margin. If your company operates with a profit margin of 25 percent on sales, for example, it means that for every $1 in sales, 75 cents goes toward producing or purchasing the items you sell and 25 cents is gross profit. To determine your current margin, you must examine your recent sales and costs to determine exactly how much profit you're making. The retail inventory method uses markup -- the specific amount your company adds to the wholesale cost of goods when pricing them for retail. If you mark up goods 25 percent, for example, then an item you buy wholesale for $80 would sell for $100 -- that is, $80 plus a 25 percent markup, which is $20.

   Which method you choose depends largely on how you run your business. If you sell products with a consistent and equal markup, retail inventory is your simplest choice. However, if you sell a range of products, each of which has a different markup, gross profit would be better, although it entails the extra step of determining your current margin

Gross Profit Method

1. The gross profit method calculation starts with the value of the goods in your inventory the last time you performed a physical count. Remember that the "value" of inventory represents the cost to you, not the retail price. Say you had inventory worth $50,000 the last time you did a hand-count. Now add the amount you have spent on goods since that count. If you've spent $30,000 since then, the total cost of goods available for sale is $80,000. Next, look at your sales revenue since the last inventory. This amount will reflect the retail price of the goods sold. Say you had $60,000 in sales. Apply your gross profit margin to your sales revenue to determine the cost of the goods you sold. If your margin is 25 percent, then that $60,000 in sales represents $15,000 in profit and $45,000 in costs. Subtract that cost figure from the total cost of available goods: $80,000 minus $45,000 gives you an estimated current inventory value of $35,000.

Retail Inventory Method

1. The calculation for the retail inventory method works much the same as that for the gross profit method. Start with the inventory cost at the last hand-count and then add to that the cost of goods purchased since the count. Say these two add up to $80,000. Now take your sales revenue since the last inventory, and calculate how much of that was the cost of the goods and how much was markup. If you had $60,000 in sales and your markup is 25 percent, then those sales represent $48,000 in costs and $12,000 in markup ($12,000 is 25 percent of $48,000). Subtract $48,000 from $80,000, and your estimated current inventory is $32,000.

Cost of goods sold and Inventory

Remember, cost of goods sold is the cost to the seller of the goods sold to customers. Cost of Goods Sold is an EXPENSE item. Even though we do not see the word Expense this in fact is an expense item found on the Income Statement as a reduction to Revenue. For a merchandising company, the cost of goods sold can be relatively large. All merchandising companies have a quantity of goods on hand called merchandise inventory to sell to customers. Merchandise inventory (or inventory) is the quantity of goods available for sale at any given time.

You will now learn how to calculate the Cost of Goods Sold using 4 different methods. The 4 methods of Cost of Goods Sold you will learn are:

• FIFO (First in, First out) – this means you will use the OLDEST inventory first to fill orders. This also means the oldest costs will appear in Cost of Goods Sold (since this is an Expense account this also means oldest costs will appear in the Income Statement). The most recent costs are shown in the Inventory asset account balances and are provided on the Balance Sheet. This is an advantage because you are now reporting Inventory at the current cost which better reflects what it would cost to replace inventory if that would become necessary due to a disaster. FIFO shows the actual flow of goods…typically you will sell the oldest inventory before the newest inventory.
• LIFO (Last in, First out) – this means you will use the MOST RECENT inventory first to fill orders. Cost of goods sold will reflect the current or most recent costs and are a better representation of matching since you are matching revenue will current costs of the inventory. The Balance Sheet will show inventory at the oldest inventory costs and may not represent current market value.
• Weighted Average (also called Average Cost) – this method is best used when the prices change from purchase to purchase and you want consistency. The weighted average method smooths out price changes so you have a steady stream of cost instead of sharp increases and decreases. You will calculate a new Average Cost after each Purchase (Sales will not change the average cost).
• Specific Identification – clearly, this will be your favorite method…it is the easiest to calculate in our examples because it specifically tells you which purchases inventory comes from. This is most often used for high priced inventory – think car sales for example. When a car dealership purchases a blue BMW convertible for $20,000 and later sells it for $60,000…they will want to show the exact cost of the BMW it sold as opposed to the cost of another car. So, specific identification exactly matches the costs of the inventory with the revenue it creates.

Okay, enough theory – how do these calculations work exactly? There are a couple of ways you can do them – there is an Inventory Record or a shortcut calculation. You will see both because they are both beneficial. Most computer systems will show you the Inventory Record form so you need to understand how to read it. However, it can be time consuming and not practical for homework and test situations so you learn the alternative method as well. We will be using the perpetual inventory system in these examples which constantly updates the inventory account balance to reflect inventory on hand. When calculating the Cost of Goods Sold for a sale, you must IGNORE the selling price. The selling price has NOTHING to do with the cost. We are trying to determine how much the items we sold originally COST us – that is the purpose behind cost of goods sold. Next thing to remember, you can only use items that occurred BEFORE the sale (meaning, you cannot use a purchase from August 28 when calculating cost of goods sold on August 14 – why? It hasn’t happened yet). We will pick inventory from the different purchases and use the purchase price to calculate the cost of goods sold.

FIFO (First in, First Out)

Under the FIFO method, we will use the oldest inventory at the time of the sale first. You must calculate Cost of Goods Sold for each sale individually. Watch this video on the FIFO Method.

Using the inventory record format, the transactions from the video would look like this under the FIFO method:

Date	Goods Purchased	Cost of Goods Sold	Inventory Balance (or Ending Inventory)
Jan 1	Beginning Balance		300 units x $10 = $3,000
Jan 2	200 x $15 = $3,000		300 units x $10 = $3,000 (from Jan 1) 200 units x $15 = $3,000 (from Jan 2) TOTALS 500 units $6,000 (sum of purchases to date, $3,000 +$ 3,000)
Jan 8		300 units x $10 = $3,000 (from Jan 1) Total COGS for 300 units $ 3,000	200 units x $15 = $3,000 (beg inventory is zero and the Jan 2 purchase remains)
Jan 11	100 x $17 = $1,700		200 units x $15 = $3,000 (from Jan 2) 100 units x $17 = $1,700 (from Jan 11) TOTALS 300 units $4,700
Jan 15		200 units x $15 = $3,000 (from Jan 2) 50 units x $17 = $850 (from Jan 11) TOTAL COGS for 250 units $3,850	50 units x $17 = $850 (from Jan 11) (Jan 2 purchase has been used and 50 units from the Jan 11 purchase remains)
Jan 18	300 x $20 = $6,000		50 units x $17 = $850 (from Jan 11) 300 units x $20 = $6,000 TOTALS (End. Inventory) 350 Units $6,850

Total cost of goods sold for January would be $6,850 (3,000 + 3,850). Sales would be Jan 8 Sales ( 300 units x $30) $9,000 + Jan 11 Sales (250 units x $40) $10,000 or $19,000. The gross profit (or margin) would be $12,150 ($19,000 Sales - 6,850 cost of goods sold). The journal entries for these transactions would be (assuming all transactions on credit):

Note: No journal entry is prepared for beginning inventory since it is a rollover from last period's ending balance.

Date	Account	Debit	Credit
Jan 2	Merchandise Inventory	3,000
	Accounts Payable		3,000
Jan 8	Accounts Receivable	9,000
	Sales		9,000
	Cost of goods sold	3,000
	Merchandise Inventory		3,000
Jan 11	Merchandise Inventory	1,700
	Accounts Payable		1,700
Jan 15	Accounts Receivable	10,000
	Sales		10,000
	Cost of goods sold	3,850
	Merchandise Inventory		3,850
Jan 18	Merchandise Inventory	6,000
	Accounts Payable		6,000

 

LIFO (Last in, First out)

Under the LIFO method, we will use most recent purchases at the time of the sale first. You must calculate Cost of Goods Sold for each sale individually. Let’s look at the this video:

Using the inventory record format, the transactions from the video would look like this under the LIFO method:

Date	Goods Purchased	Cost of Goods Sold	Inventory Balance (or Ending Inventory)
Jan 1	Beginning Balance		300 units x $10 = $3,000
Jan 2	200 x $15 = $3,000		300 units x $10 = $3,000 (from Jan 1) 200 units x $15 = $3,000 (from Jan 2) TOTALS 500 units $6,000 (sum of purchases to date, $3,000 +$ 3,000)
Jan 8		200 units x $15 = $3,000 (from Jan 2) 100 units x $10 = $1,000 (from Jan 1) Total COGS for 300 units $ 4,000	200 units x $10 = $2,000 (from Jan 1) (Jan 2 purchase has been used and 200 units from Jan 1 remain)
Jan 11	100 x $17 = $1,700		200 units x $10 = $2,000 (from Jan 1) 100 units x $17 = $1,700 (from Jan 11) TOTALS 300 units $3,700
Jan 15		100 units x $17 = $1,700 (from Jan 11) 150 units x $10 = $1,500 (from Jan 1) TOTAL COGS for 250 units $3,200	50 units x $10 = $500 (from Jan 1) (Jan 11 purchase has been used and 50 units from the Jan 1 beg bal remains)
Jan 18	300 x $20 = $6,000		50 units x $10 = $500 (from Jan 1) 300 units x $20 = $6,000 TOTALS (End. Inventory) 350 Units $6,500

Total cost of goods sold for the month would be $7,200 (4,000 + 3,200). Since total Sales would the same as we calculated above Jan 8 Sales ( 300 units x $30) $9,000 + Jan 11 Sales (250 units x $40) $10,000 or $19,000. The gross profit (or margin) would be $11,800 ($19,000 Sales - 7,200 cost of goods sold). The journal entries for these transactions would be would be the same as show above the only thing changing would be the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.

Weighted Average (or Average Cost)

The Weighted Average method strives to smooth out price changes during the period. To do this, we will calculate an average cost of inventory at the end of the month under the periodic method (perpetual method calculates average cost of inventory after each purchase). Sales of inventory will not affect the average cost of inventory. It does NOT matter which purchase the inventory comes from when using the average cost method. Instead, we will use the average cost calculated to determine cost of goods sold for any sales transactions. Average Cost is calculated by taking the TOTAL COST of INVENTORY / TOTAL INVENTORY QUANITY. Let’s look at a video:

The Inventory Record for this information in the video would be:

	Purchases	Cost of goods sold	Inventory Balance	Avg Cost
Jan 1			300 units $3,000	$10.00	($3,000 / 300 units)
Jan 2	200 units x $15 = $3,000		500 units $6,000 (add Jan 1 and Jan 2 together)	$12.00	($6,000 / 500 units)
Jan 8		300 units x $12 avg cost = $3,600	200 units $2,400 (take Jan 2 balance - Jan 8 cogs)
Jan 11	100 units x $17 = $1,700		300 units $4,100 (add Jan 8 balance and Jan 11 purchase)	13.67 (rounded)	($4,100 / 300 units)
Jan 15		250 units x $13.67 avg cost = $3,417.50	50 units $682.50** (take Jan 11 balance - Jan 15 cogs)
Jan 16	300 units x $20 = $6,000		350 units $6,682.50 (add Jan 15 balance and Jan 16 purchase)	19.09 (rounded)	($6,682.50 / 350 units)

**Jan 15 and 16 off a little from the information in the video due to rounding of the average cost. Total cost of goods sold for January would be $7,017.50 ($3600 + 3,417.50). Since total Sales would the same as we calculated before $19,000. The gross profit (or margin) would be $11,982.50 ($19,000 Sales - 7017.50 cost of goods sold). The journal entries for these transactions would be would be the same as show above the only thing changing would be the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.

Specific Identification

Finally, the last method – we are saving the easiest one for last. Specific identification will tell you exactly which purchase to use when determining cost. Easy, huh? No guess work, no hard thinking – just take the information given and calculate based on the purchase prices given. Let's look at another example:

Date	Description	Qty	Price per Unit	Total Amount
May 1	Beginning Inventory	150	$ 300	$ 45,000
May 6	Purchase	350	350	122,500
May 17	Purchase	80	450	36,000
May 25	Purchase	100	458	45,800
May 30	Sold	300	1,400	420,000

• On May 9, you sold 180 units consisting of 80 units from beginning inventory and 100 units from the May 6 purchase.
• May 30 sold 300 units consisting of 200 units from the May 6 purchase and 100 units from the May 25 purchase

Using an Inventory Record, cost of goods sold would look like this:

Date	Goods Purchased	Cost of Goods Sold	Inventory Balance
May 1	Beginning Balance		150 x $300 = $ 45,000
May 6	350 x $350 = $122,500		150 x $300 = $45,000 350 x $350 = 122,500 TOTALS 500 units $167,500
May 9		80 x $300 = 24,000 100 x $350 = 35,000 COGS 180 units $ 59,000	70 x $300 = $21,000 250 x $350 = 87,500 TOTALS 320 units $108,500
May 17	80 x $450 = $36,000		70 x $300 = $21,000 250 x $350 = 87,500 80 x $450 = 36,000 TOTALS 400 units $144,500
May 25	100 x $458 = $45,800		70 x $300 = $21,000 250 x $350 = 87,500 80 x $450 = 36,000 100 x $458 = 45,800 TOTALS 500 units $190,300
May 30		200 x $350 = 70,000 100 x $458 = 45,700 COGS 300 units $ 174,800	70 x $300 = $21,000 50 x $350 = 17,500 80 x $450 = 36,000 End. Inventory 200 units $74,500

The total cost of goods sold for May would be $233,800 (59,000 + 174,800). //www.openassessments.org/assessments/1275

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• FIFO Method, First in First out Method for Expensing Inventory. Authored by: Note Pirate. License: All Rights Reserved. License terms: Standard YouTube License
• LIFO Method, Last In First Out Method for Expensing Inventory. Authored by: Note Pirate. License: All Rights Reserved. License terms: Standard YouTube License
• Weighted Average Cost Flow Method for Expensing Inventory. Authored by: Note Pirate. License: All Rights Reserved. License terms: Standard YouTube License
• Specific Identification Method and Expensing Inventory. Authored by: Note Pirate. License: All Rights Reserved. License terms: Standard YouTube License