INVENTORY COSTING METHODS

The inventory records of ABC Merchandising showed the following data relative to a particular item sold regularly.
(Assume transactions in the order given):

Transaction Units Unit Cost

1. Beginning Inventory 2,000 50
2. Purchases 18,000 52
3. Sales (at P130 per unit) 7,000
4. Purchases 6,000 55
5. Sales (at P135 per unit) 16,000
6. Purchases 3,000 60

Determine the cost of ending inventory, cost of goods sold and gross profit under each of the following methods.
1. Specific Identification Method (Sales of No. 3 originated from the purchased of No. 2; while sales of No. 5
originated from No. 2 (11,000 units) and No. 4 (5,000 units)
2. FIFO Method
3. Moving Average Method

Solution:
1. Specific Identification Method

Cost of ending inventory

From No. 1 2,000 x P50 P100,000

From No. 4 1,000 x P55 55,000
From No. 6 3,000 x P60 180,000
Total cost of P335,000
ending inventory

Cost of goods sold

From No. 3 7,000 x P52 P364,000

From No. 5 11,000 x P52 572,000
5,000 x P55 275,000
Total cost of P1,211,000
goods sold

Gross profit
Sales 7,000 x P130 910,000
16,000 x P135 2,160,000 3,070,000
Less cost of goods 1,211,000
sold
Gross Profit 1,859,000

2. FIFO Method

Transaction Received Issued Balance

1 2,000 @ 50 = 100,000
2 18,000 @ 52 = 936,000 2,000 @ 50 = 100,000
18,000 @ 52 = 936,000
3 2,000 @ 50 = 100,000 13,000 @ 52 = 676,000
5,000 @ 52 = 260,000
4 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000
6,000 @ 55 = 330,000
5 3,000 @ 60 = 180,000 3,000 @ 55 = 165,000
3,000 @ 60 = 180,000
6 CGS = 1,201,000 Inventory, end = 345,000
 Gross Profit

Sales P3,070,000
Less cost of goods sold 1,201,000
Gross profit P1,869,000

Moving Average Method

Transactio Received Issued Balance

n
1 2,000 @ 50 = 100,000
2 18,000 @ 52 = 936,000 20,000 @ 51.80 =1,036,000
3 7,000 @ 51.80 13,000 @51.80 = 673,000
4 6,000 @ 55 = 330,000 19,000 @52.81 = 1,003,400
5 16,000 @ 52.81 = 844,960 3,000 @ 52.81 = 158,440
6 3,000 @60 = 180,000 6,000 @ 56.41 = 338,400

The procedures for the maintenance of the stock card under the moving average are as follows:

 The number of units and total cost of the goods received are added to the previous respective balances to
derive the new number of units on hand and the total cost of goods on hand. The total cost shall be
divided by the total number of units to determine the moving average unit cost. Thus, the 18,000 units
purchased, in transaction 2, plus 2,000 units previously on hand equals 20,000; P936,000 cost of
purchases of 18,000 units is added to the cost of the previous inventory, P100,000; the sum is P1,036,000.
P1,036,000 is divided by 20,000 units, resulting to a moving average unit cost, after transaction 2, of
P51.80.

 The number of units sold (or issued) is deducted from the previous units on hand to determine the new
number of units on hand after the issue. The cost of the units issued (which is number of units issued x the
average unit cost before issuance) is deducted from the previous total cost of goods on hand. The unit cost
remains unchanged. (Thus, 7,000 x P51.80 = 362,600 and P1,036,000 – 362,600 = P673,400; P673,400 /
13,000 = P51.80.)

The cost of ending inventory after transaction 6, is the last figure in the balance column which is P338,400. The
cost of goods sold is the total cost in the issued column, P1,207,560. The gross profit is 1,862,440 (P3,070,000 –
P1,207,560).

MEASUREMENT OF INVENTORIES SUBSEQUENT TO INITIAL RECOGNITION

Inventories, on the statement of financial position, should be measured at the lower of cost and net realizable
value. Cost is determined by applying the specific cost formula used by the enterprise. Net realizable value is defined as
the estimated selling price in the ordinary course of business less the estimated costs of completion and estimated costs
necessary to make the sale.
The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or
partially obsolete, or if their selling prices have declined. The cost of inventories may not also be recoverable if the
estimated costs of completion or the estimated costs to make the sale have increased. The practice of writing inventories
down below cost to net realizable value is consistent with the view that assets should not be carried in excess of amounts
to be realized from their sale or use.
Inventories are usually written down to net realizable value on an item-by-item basis. In some circumstances,
however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to
the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area,
and cannot be practicably evaluated separately from other items in that product line. It is not appropriate to write
inventories down on the basis of a classification of inventory, for example, finished goods, or all the inventories in a
particular industry or geographical segment.
Estimates of net realizable value are based on the most reliable evidence at the time the estimates are made as to
the amount of inventories are expected to realize. These estimates take into consideration fluctuations of price as well as
the purpose for which the inventory is held. For example, the net realizable value of the quantity of inventory held to
satisfy firm sales or service contracts is based on the contract price. If the sales contracts are for less than the inventory
qualities held, the net realizable value of the excess is based on general selling prices.
Materials and other supplies held for use in the production of inventories are not written down below cost if the
finished products in which they will be incorporated are expected to be sold at or above cost. However, when a decline in
the price of materials indicates that the cost of the finished products exceeds net realizable value, the materials are written
down to net realizable value. In such circumstances, the replacement cost of materials may be the best available measure
of their net realizable value.

To illustrate the application of the lower of cost and net realizable value rule, assume the following information for
different inventory items held by XYZ Company at December 31, 2022:

Item Cost Sales Price Selling Expense Units

A 185.00 230.00 35.00 5,000
B 69.00 100.00 30.00 20,000
C 31.00 43.00 15.00 15,000
D 75.00 105.00 37.00 18,000

The total cost of inventory is determined as follows:

A 5,000 x P185.00 P925,000

B 20,000 x P69.00 1,380,000
C 15,000 x P31.00 465,000
D 18,000 x P75.00 1,350,000
Total P4,120,000

The inventory value is determined as follows:

Item Cost NRV Lower of cost and NRV Units Total Inventory Value
(SP – Selling Expense)
A 185.00 195.00 185.00 5,000 925,000
B 69.00 70.00 69.00 20,000 1,380,000
C 31.00 28.00 28.00 15,000 420,000
D 75.00 68.00 68.00 18,000 1,224,000
Total P3,949,000

Thus, from total cost of P4,120,000 to total value of inventory using lower of cost and net realizable value of P3,949,000,
there is inventory write down amounting to P171,000.00

Write Down of Inventory

The amount of any write-down of inventories to net realizable value should be recognized as an expense in the
period the write down occurs.
The write down of inventory cost to lower of cost and net realizable value may be recorded using either direct or
allowance method. Some entities find the allowance method more convenient to adopt since the method uses a separate
valuation account and a separate loss account and the effects of the write down and its subsequent recovery can be clearly
identified in the entity’s statement of comprehensive income.
Assume the following data for ABC Merchandising. The company uses periodic system and FIFO cost allocation.

12/31/2020 12/31/2021 12/31/2022

Cost 500,000 520,000 600,000
Lower of cost and NRV 480,000 490,000 575,000
Assuming the same information, but the company uses perpetual inventory system, journal entries to reflect the valuation
of the lower of cost and net realizable value are:

Presentation in Profit or Loss

The effects of adjusting the inventory to lower of cost and net realizable value are shown on the face of the
statement of comprehensive income.
The foregoing illustration for ABC Merchandising and the other information below are used to present the effects
of the application of the lower of cost and net realizable value.

2022 2021
Sales 3,500,000 3,000,000
Purchases 2,000,000 1,800,000
General and Administrative Expenses 850,000 750,000
Direct Method

Under this method, the beginning and ending inventories are directly measured at the lower of cost and net realizable
value in the computation of cost of goods sold.

The inventories are reported directly at the lower of cost and net realizable value; hence, the decline in net realizable value
is absorbed by the cost of goods sold. Other than cost of goods sold, no other line item relating to decline in (or recovery
of) net realizable value of inventory is presented on the face of the profit or loss.

Allowance Method
Under the allowance method, both the beginning and ending inventories are measured at cost in the computation
of the cost of goods sold. The adjustment in the balance of the allowance is presented as other income(recovery) or other
operating expenses (decline) in profit or loss.