Lesson 10

INVENTORY COST FLOW

Learning Objectives
After studying the chapter, you should be able to
1. To identify the cost formulas required by IFRS.
2. To apply the FIFO cost formula.
3. To apply the weighted average cost formula.
4. To apply the specific identification method.

Cost formulas

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using either:

a. First in, First out
b. Weighted average

The standard does not permit anymore the use of the last in, first out (LIFO) as an alternative formula in measuring cost of inventories.

First in, First out (FIFO)

The FIFO method assumes that “the goods first purchased are first sold” and consequently the goods remaining in the inventory at the end of the period are those most recently purchased
or produced.

In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods are sold in the order they are purchased.

The rule is “first come, first sold”.

The inventory is thus expressed in terms of recent or new prices while the cost of goods sold is representative of earlier or old prices.

This method favors the statement of financial position in that the inventory is stated at current replacement cost.

The objection to the method is that there is improper matching of cost against revenue because the goods sold are stated at earlier or older prices resulting in understatement of cost of
sales.

Accordingly, in a period of inflation or rising prices, the FIFO method would result to the highest net income.

However, in a period of deflation or declining prices, the FIFO method would result to the lowest net income.

ILLLUSTRATION

The following data pertain to an inventory item:

Sales
Units Unit Cost Total Cost
(units)
Jan -1 800 200 160,000
8 500
18 700 210 147,000
22 800
31 500 220 110,000

Ending Inventory is 700 units

Solution: (800-500+700-800+500) = 700

FIFO – Periodic - Computation of Cost of Ending inventory

The cost of ending inventory is based on remaining units not sold, see analysis of table below:
Purchases Sold Units Balance
Jan -1 800 800
8 500 300
18 700 1000 Unit cost of 210, units remaining from
22 800 200 700 units
31 500 700
Ending Inventory
Has unit cost of 220

Therefore, the breakdown of 700 units is from 200 units from 700 units purchase from Jan 18, and the latest purchase
on January 31.
Jan Unit Unit Cost Cost
18 200 210 42,000
31 500 220 110,000
700 152,000

FIFO – Periodic - Computation of Cost of Goods Sold

FIFO, Meaning UNITS SOLD are UNITS FIRST PURCHASED

Therefore, the first 500 units sold on January 8 was from beginning inventory (800 units with P200 unit cost) while the
800 units sold on January 22, was from 300 units from beginnning inventory (800 - 500 (jan 8)) =300) and 500 units
from purchases on January 18 with unit cost of 210

Jan Unit Unit Cost Cost

8 800 200 160,000
18 500 210 105,000
700 265,000

Other computation using the Cost of Goods Sold Format

Cost of Goods Sold

Inventory - January 1 160,000

Purchases (Jan 18) 147,000
(Jan 31) 110,000 257,000
Goods Available for sale 417,000
Ending Inventory - January 31 (152,000)
Cost of goods sold 265,000
 FIFO – Perpetual

Purchases Sales (CGS) Inventory Balance

Date Units Unit Cost Total Cost Units Unit Cost Total Cost Units Unit Cost Total Cost
1-Jan 800 200 160,000

8 500 200 100,000 300 200 60,000

18 700 210 147,000 700 210 147,000

22 300 200 60,000

500 210 105,000 200 210 42,000
31 500 220 110,000 500 220 110,000
1300 265,000 700 152,000

The table shows the updated balances of each cost

Weighted average – Periodic

The cost of the beginning inventory plus the total cost of purchases during the period is divided by the total units purchased plus those in the beginning inventory to get a weighted
average unit cost.

Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value.

In other words, the average unit cost is computed by dividing the total cost of goods available for sale by the total number of units available for sale.

ILLUSTRATION

FIFO – Periodic - Computation of Cost of Ending inventory

Jan Unit Unit Cost Cost

1 800 200 160,000
18 700 210 147,000
31 500 220 110,000
TGAS 2000 417,000

Weighted Average Unit Cost (417,000 / 2,000) = 208.50

ENDING INVENTORY = 700 units same as above

700 X 208.5 145,950

COST of Goods Sold = 1,300 units same as above

1,300 X 208.5 271,050

Other computation using the Cost of Goods Sold Format

Cost of Goods Sold

Inventory - January 1 160,000

Purchases (Jan 18) 147,000
(Jan 31) 110,000 257,000
Goods Available for sale 417,000
Ending Inventory - January 31 (145,950)
Cost of goods sold 271,050

Weighted average – Perpetual or "MOVING AVERAGE METHOD"

When used in conjunction with the perpetual system, the weighted average method is popularly known as the moving average method.

PAS 2, paragraph 27, provides that the weighted average may be calculated on a periodic basis or as each additional shipment is received depending upon the circumstances of the entity.

Under this method, a new weighted average unit cost must be computed after every purchase and purchase return.

Thus, the total cost of goods available after every purchase and purchase return is divided by the total units available for sale at this time to get a new weighted average unit cost.

Such new weighted average unit cost is then multiplied by the units on hand to get the inventory cost.

This method requires the keeping of inventory stock card in order to monitor the “moving” unit cost after every purchase.

ILLUSTRATION

FIFO – Periodic - Computation of Cost of Ending inventory

Jan Unit Unit Cost Cost

1 Balance 800 200 160,000
8 Sale (500) 200 (100,000)

Balance 300 200 60,000

18 Purchase 700 210 147,000

Total 1,000 207 207,000 Unit Cost Computation (207,000 /1,000)

22 Sale (800) 207 (165,600)

Balance 200 207 41,400

31 Purchase 500 220 110,000
Total 700 216 151,400 Unit Cost Computation (151,400 /700)

Weighted Average Unit Cost (417,000 / 2,000) = 208.50

ENDING INVENTORY = 700 units same as above

700 X 216 151,400

COST of Goods Sold = 1,300 units same as above

8-Jan 500 X 200 100,000

22-Jan 800 X 207 165,600
265,600
 Other computation using the Cost of Goods Sold Format

Cost of Goods Sold

Inventory - January 1 160,000

Purchases (Jan 18) 147,000
(Jan 31) 110,000 257,000
Goods Available for sale 417,000
Ending Inventory - January 31 (151,400)
Cost of goods sold 265,600

ANOTHER ILLUSTRATION - Effect of Purchase Returns - Moving Average

Jan Unit Unit Cost Cost

1 Balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000

Balance 10,000 225 2,250,000

15 Sale (7,000) 225 (1,575,000)
Observe that the moving average unit cost changes every time
Balance 3,000 225 675,000 there is a new purchase or a purchase return. The moving average
16 Sale Return 1,000 225 225,000 unit cost is not affected by a sale or a sale return.

Balance 4,000 225 900,000

30 Purchase 16,000 150 2,400,000

Balance 20,000 165 3,300,000

Purchase
31 (2,000) 150 (300,000)
Return
Balance 18,000 167 3,000,000

Weigthed Average - Periodic

Jan Unit Unit Cost Cost

1 Beg Bal 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
30 Purchase 16,000 150 2,400,000
Purchase
31 (2,000) 150 (300,000)
Return
24,000 4,350,000

Weighted Average Unit Cost (4,250,000 / 24,000) = 181.25

ENDING INVENTORY = 700 units same as above

18,000 X 181.25 3,262,500

COST of Goods Sold = 1,300 units same as above

6,000 X 181.25 1,087,500

Specific identification

Specific identification means that specific costs are attributed to identified items of inventory.

The cost of the inventory is determined by simply multiplying the units on hand by their actual unit cost.

This requires records which will clearly determine the actual costs of goods on hand.

PAS 2, paragraph 23, provides that this method is appropriate for inventories that are segregated for a specific project and inventories that are not ordinarily interchangeable.

The specific identification method may be used in either periodic or perpetual inventory system.

The major argument for this method is that the flow of the inventory cost corresponds with the actual physical flow of goods.

With specific identification, there is an actual determination of cost of units sold and on hand.

The major argument against this method is that it is very costly to implement even with high-speed computers.

Standard costs

Standard costs are predetermined product costs established on the basis of normal levels of materials and supplies, labor, efficiency and capacity utilization.

Observe that a standard cost is predetermined and, once determined, is applied to all inventory movements – inventories, goods available for sale, purchases and goods sold or placed in
production.

PAS 2, paragraph 21, states that the standard cost method may be used for convenience if the results approximate cost.

However, the standards set should be realistically attainable and are reviewed and revised regularly in the light of current conditions.

Standard costing is taken up in a higher accounting course and is not discussed further in this book.

Overhead cost is computed using the applied/predetermined overhead/standard rate by correspondng variable rate per unit and applied fixed cost per unit (Fixed total cost/
normal capacity or per direct labors required)

Relative sales price method

When different commodities are purchased at a lump sum, the single cost is apportioned among the commodities based on their respective sales price. This is based on the philosophy that cost is proportionate to selling price.

For example, products A, B and C are purchased at “basket price” of P3,000,000. Assume that the said products have the following sales price: A P500,000, B P1,500,000, and C P3,000,000.

Computation of cost of each product

Cost of each inventory
Product A 500,000 5/50 X 3,000,000 300,000
Product B 1,500,000 15/50 X 3,000,000 900,000
Product C 3,000,000 30/50 X 3,000,000 1,800,000
5,000,000 3,000,000

End of topic