Inventory Costing Methods
Even a casual observer of the stock markets will note that stock values often move significantly on information about a company's earnings. Now, you may be wondering why a discussion of inventory would begin with this observation. The reason is that inventory measurement bears directly on the determination of income! Recall from earlier chapters this formulation:
Notice that the goods available for sale are "allocated" to ending inventory and cost of goods sold. In the graphic, the units of inventory appear as physical units. But, in a company's accounting records, this flow must be translated into units of money. After all, the balance sheet expresses inventory in money, not units. And, cost of goods sold on the income statement is also expressed in money:
This means that allocating $1 less of the total cost of goods available for sale into ending inventory will necessarily result in placing $1 more into cost of goods sold (and vice versa). Further, as cost of goods sold is increased or decreased, there is an opposite effect on gross profit. Remember, sales minus cost of goods sold equals gross profit. Thus, a critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold:
Determining the Cost of Ending Inventory
In earlier chapters, the dollar amount for inventory was simply given. Not much attention was given to the specific details about how that cost was determined. To delve deeper into this subject, let's begin by considering a general rule: Inventory should include all costs that are "ordinary and necessary" to put the goods "in place" and "in condition" for their resale.
This means that inventory cost would include the invoice price, freight-in, and similar items relating to the general rule. Conversely, "carrying costs" like interest charges (if money was borrowed to buy the inventory), storage costs, and insurance on goods held awaiting sale would not be included in inventory accounts; instead those costs would be expensed as incurred. Likewise, freight-out and sales commissions would be expensed as a selling cost rather than being included with inventory.
Once the unit cost of inventory is determined via the preceding rules of logic, specific costing methods must be adopted. In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold).
To solidify this point, consider a simple example: Mueller Hardware has a storage barrel full of nails. The barrel was restocked three times with 100 pounds of nails being added at each restocking. The first batch cost Mueller $100, the second batch cost Mueller $110, and the third batch cost Mueller $120. Further, the barrel was never allowed to empty completely and customers have picked all around in the barrel as they bought nails from Mueller (and new nails were just dumped in on top of the remaining pile at each restocking). So, its hard to say exactly which nails are "physically" still in the barrel. As you might expect, some of the nails are probably from the first purchase, some from the second purchase, and some from the final purchase. Of course, they all look about the same. At the end of the accounting period, Mueller weighs the barrel and decides that 140 pounds of nails are on hand (from the 300 pounds available). The accounting question you must consider is: what is the cost of the ending inventory? Remember, this is not a trivial question, as it will bear directly on the determination of income! To deal with this very common accounting question, a company must adopt an inventory costing method (and that method must be applied consistently from year to year). The methods from which to choose are varied, generally consisting of one of the following:
o First-in, first-out (FIFO)
o Last-in, first-out (LIFO)
Each of these methods entail certain cost-flow assumptions. Importantly, the assumptions bear no relation to the physical flow of goods; they are merely used to assign costs to inventory units. (Note: FIFO and LIFO are pronounced with a long "i" and long "o" vowel sound). Another method that will be discussed shortly is the specific identification method; as its name suggests, it does not depend on a cost flow assumption.