Periodic Inventory - FIFO, LIFO, and Average Cost: Videos & Practice Problems

In a periodic inventory system, businesses utilize different cost flow assumptions—FIFO (First In, First Out), LIFO (Last In, First Out), and average cost—to manage the cost of goods sold (COGS) and inventory valuation. Unlike a perpetual system, where COGS is recorded after each sale, a periodic system only calculates COGS at the end of the accounting period. This approach is particularly useful when dealing with large quantities of identical units, such as cans of soda, where individual items cannot be distinguished from one another.

FIFO assumes that the oldest inventory items are sold first. Therefore, the COGS reflects the cost of the earliest purchased units. This method can be beneficial in times of rising prices, as it results in lower COGS and higher ending inventory values, which can enhance reported profits.

Conversely, LIFO assumes that the most recently acquired inventory is sold first. This means that COGS will reflect the cost of the latest purchases. In an inflationary environment, LIFO can lead to higher COGS and lower taxable income, which may be advantageous for cash flow management.

The average cost method calculates COGS based on the average cost of all units available for sale during the period. To determine the average cost per unit, the total cost of inventory is divided by the total number of units purchased. This method smooths out price fluctuations over time, providing a consistent cost basis for inventory valuation.

It is important to note that the chosen cost flow assumption does not need to align with the actual physical flow of goods. For instance, even in a LIFO system, a business might choose to sell older inventory first due to factors like expiration dates. The physical inventory count at the end of the period will reveal the remaining stock, which is essential for calculating ending inventory.

To summarize the inventory management process, the formula for determining the ending inventory is:

\[\text{Ending Inventory} = \text{Beginning Inventory} + \text{Purchases} - \text{COGS}\]

Additionally, the concept of goods available for sale is crucial, defined as:

\[\text{Goods Available for Sale} = \text{Beginning Inventory} + \text{Purchases}\]

This total represents all inventory that could potentially be sold during the period, with items either contributing to COGS or remaining in ending inventory. Understanding these cost flow assumptions and their implications is vital for effective inventory management and financial reporting.

In a periodic inventory system, the cost of goods sold (COGS) and ending inventory are calculated at the end of the accounting period rather than continuously. For the month of July, a company had an initial inventory of 1,000 units and made additional purchases of 500 and 600 units, resulting in a total of 2,100 units available for sale. After a physical count, it was determined that 800 units remained at the end of the month. This means that 1,300 units were sold during the period, calculated by subtracting the ending inventory from the total available for sale.

To determine COGS using the First-In, First-Out (FIFO) method, the oldest inventory is sold first. The initial 1,000 units from the beginning inventory were sold at $20 each, totaling $20,000. Since 1,300 units were sold, an additional 300 units were taken from the first purchase at $22.40 each, amounting to $6,720. Therefore, the total COGS under FIFO is:

COGS = 20,000 + 6,720 = 26,720

For the ending inventory, the remaining units consist of the most recently purchased items. The 600 units from the last purchase at $23.30 each contribute $13,980 to the ending inventory. Additionally, 200 units from the July 11 purchase at $22.40 each add another $4,480. Thus, the total ending inventory is calculated as follows:

Ending Inventory = 13,980 + 4,480 = 18,460

Next, the Last-In, First-Out (LIFO) method will be explored, where the most recently purchased inventory is sold first, followed by the older inventory. This approach will yield different values for COGS and ending inventory, reflecting the impact of inventory valuation methods on financial statements.

In inventory management, understanding the Last In, First Out (LIFO) method is crucial for accurately calculating the cost of goods sold (COGS) and ending inventory. In this scenario, we have a total of 2,100 units available for sale, which includes an initial stock and two subsequent purchases. After selling 1,300 units, we are left with 800 units in inventory.

Under the LIFO method, the most recently purchased items are sold first. Therefore, we begin by selling the 600 units purchased on July 30th, priced at $23.30 each. This results in a COGS of:

$$600 \times 23.30 = 13,980$$

Next, we sell 500 units from the subsequent purchase at $22.40 each, contributing:

$$500 \times 22.40 = 11,200$$

At this point, we have sold a total of 1,100 units, but we need to reach 1,300 units sold. To do this, we take 200 units from the oldest inventory, which is priced at $20 each:

$$200 \times 20 = 4,000$$

Adding these amounts together gives us the total COGS under LIFO:

$$13,980 + 11,200 + 4,000 = 29,180$$

This total reflects the cost of goods sold using the LIFO method, which differs from the First In, First Out (FIFO) method due to the selection of different unit costs. It is important to note that neither method is inherently more correct; consistency in the chosen method is key for accurate financial reporting.

For the ending inventory, we have 800 units remaining, which are the oldest units from the July 1st balance. Therefore, the ending inventory value is calculated as:

$$800 \times 20 = 16,000$$

In summary, using the LIFO method, the cost of goods sold is $29,180, and the ending inventory is valued at $16,000. Understanding these calculations is essential for effective inventory management and financial analysis.

The average cost method is a straightforward approach to inventory valuation that involves calculating the average cost per unit of goods available for sale. To determine this average cost, you first need to find the total cost of all goods and the total quantity available. The formula for average cost is given by:

Average Cost = \(\frac{\text{Total Cost}}{\text{Quantity}}\)

In this scenario, the total quantity available for sale is 2,100 units. To find the total cost, you calculate the cost of each shipment. For example, if you have:

• 1,000 units at $20 per unit, the total cost is \(1,000 \times 20 = 20,000\).
• 500 units at $22.40 per unit, the total cost is \(500 \times 22.40 = 11,200\).
• 600 units at $23.30 per unit, the total cost is \(600 \times 23.30 = 13,980\).

Adding these amounts together gives a total cost of:

Total Cost = 20,000 + 11,200 + 13,980 = 45,180

Now, using the total cost and total quantity, you can calculate the average cost per unit:

Average Cost = \(\frac{45,180}{2,100} \approx 21.51\)

With the average cost established, you can easily determine the cost of goods sold (COGS) and the ending inventory. If 1,300 units were sold (2,100 total units minus 800 units remaining in inventory), the COGS can be calculated as:

COGS = 1,300 \times 21.51 = 27,963

To find the ending inventory, you can either subtract the COGS from the total cost or calculate it directly using the average cost:

Ending Inventory = Total Cost - COGS = 45,180 - 27,963 = 17,217

Alternatively, calculating the ending inventory directly using the average cost gives:

Ending Inventory = 800 \times 21.51 = 17,208

While both methods yield similar results, discrepancies may arise due to rounding. Therefore, the most accurate approach is to subtract the COGS from the total cost to ensure all figures are accounted for. This method highlights the importance of precision in financial calculations, especially in larger companies where even minor discrepancies can accumulate significantly.

In summary, the average cost method simplifies inventory management by allowing businesses to use a consistent cost per unit for both COGS and ending inventory calculations, making it an effective tool for financial reporting.