Question

explain how the different cost flow assumptions affect ending inventory and cost of goods sold in times of rising prices and times of decreasing prices.

Answer 1

Below are the usually used cost flow assumptions for calculating ending inventory and how they affect the ending inventory balance and COGS:

FIFO - First in First out - In this method, the underlying presumption is that the goods that were purchased first, will be used in production first. When the prices are rising, under this method inventory is calculated at the latest price which is higher and the units transferred to production are at a lower price. COGS is lower and net income is higher. However, when the prices re decreasing, the inventory is stated at a lower price and COGS are at a higher price thereby reducing the profits or net income.

For Ex: If 10 units are purchased @$8 in Jan, 10 more @$9 in Feb and 10 more in March @$10, if 25 units were sold, ending inventory is 5*$10 = $50, COGS is $(80+90+50) = $220

If the prices are the other way round, ending inventory will be 5*$8 = 40, COGS will be $(100+90+40)= $230

LIFO - Last in first out - In this method, the underlying assumption is that items purchased last are sold first. If the prices are rising, the COGS will be valued at the latest (higher prices) and Inventory at lower prices there by reducing profits. However, prices are falling, COGS will be at lower prices and Inventory at higher prices, thereby increasing the profits.

Let's consider the same example: If we use LIFO and the prices are rising, COGS will (10*10)+(10*9)+(5*8) = $230 and Inventory is $40. If the prices are falling, COGS = (10*8)+(10*9)+(5*10) = $220 and inventory is $50, thereby increasing the profits by $10

Specific Identification method - In this case specific inventory is identified and moved, relevant costs will be tracked accordingly. Let's say XYZ Inc purchased 3 items at A $85, B $105 and C $90 each. When each of these items are sold, the cost of it will be removed from inventory to COGS. The increase or decrease in prices do not affect this type of system. However, this system is seldom used in markets where simlar goods are bought and sold. For ex: If a wholesale company buys computers from a manufacturer and sells them to retailer, it can hardly use this method. This method is more suitable for dealers in arts.

Weighted Average cost method - The COGS is calculated as follows:

Total cost of purchases / total number of units purchased.

If a company uses perpetual inventory system, then the above formula will be used at each purchase to recompute the weighted average, In such a scenario, if the prices are rising, the weighted average will keep going up, the ending inventory will be valued at the highest average and cost of goods sold could be at a lower average or the same at that of the average.

If the prices are falling, the weighted average will also keep coming down, ending inventory will be valued at a lower average (however still higher than the last purchase price) and COGS will be relatively higher as well.

Lets take the first example:

10 Units in Jan @ $8

5 of these were sold in Jan

So the ending Inventory = 5*8 = $40

If 10 more are purchased in Feb @$9 each, the inventory balance on the date of purchase will be 40+90 = $130, weighted average = 130/15 = $8.67

If 8 of these are sold, COGS = 8*8.67 = 69.34, ending Inventory will be 7*8.67 = $60.66.

If we had used FIFO, then COGS would have been (5*8)+(3*9) = 67, Inventory would have been 7*9 = 63

If we had used LIFO, then COGS would have been 8*9 = 72, Inventory (2*9)+(5*8)= 58

Conclusion:

When the prices are rising, FIFO method will have lowest COGS, LIFO will have highest and Weighted average as the name suggests will have COGS at an average price. It means under FIFO, there will be highest profit, LIFO will be lowest and Weighted avg will give moderate profit

When the prices are falling COGS and net profit will be vice versa.