Understanding Inventory Cost Flow Assumptions

Current inventory levels affect the balance sheet of a company. The amount of product multiplied by the cost determines the amount of inventory reflected on the balance sheet. Inventory valuation is easy for companies selling small quantities of high value products because the number of items in inventory at any given time is small. Larger retailers like Wal-Mart and Costco have greater difficulty assigning inventory values and costs of goods sold because of the large number of products that flow in and out. To make this process easier there are multiple methods of assigning value to inventory. We will detail these methods through a fictional company, Candy Inc., to better understand how each affects inventory value and cost of goods sold at the end of the fiscal year.
Candy Inc. sells on average four million lollipops per year. They purchase their inventory every quarter based on the previous quarter’s sales. In 2008 Candy Inc. purchased 300,000 lollipops on January 1, 250,000 lollipops on April 1, 350,000 on July 1 to account for summer demand and 250,000 on October 1 to account for the remainder of the year. In 2008 the candy industry experienced its highest levels of inflation, rising costs, in 50 years. Each quarter saw a 25 cent increase because of the rising costs of sugar. As product flowed in and out of Candy Inc. it became impossible to assign actual value to the cost of goods sold and the current inventory. This example will help us understand the four inventory cost flow assumptions and how they affect current assets and net income.
The four inventory cost flow assumptions are specific identification, weighted average, FIFO (first-in, first-out) and LIFO (last-in, first-out). Specific identification is assigning value of the cost of goods sold and the current inventory based on the actual price paid. For Candy Inc. the cost of each lollipop from the manufacturer would be assigned to each lollipop. The problem Candy Inc would experience given the volume of candy sold is mixed up inventories which would make it virtually impossible to know the true cost of a single lollipop when it was sold to a consumer.
Another cost option is the weighted average cost flow assumption. Under this assumption the average price paid for the lollipops would be determined and assigned to remaining inventory and cost of goods sold. In our example, each quarter saw a 25 cent increase. In January lollipops cost 25 cents, in April they cost 50 cents, in July they cost 75 cents and in October they cost 1 dollar. In the weighted average model the total cost of inventory purchased for 2008 is $712,500.00 (300,000 X $0.25, 250,000 X $0.50, 350,000 X $0.75, 250,000 X $1.00). The average price paid per lollipop is $0.62 ($712,500 divided by 1,150,000). If Candy Inc. sold 1 million lollipops in 2008 150,000 lollipops remained at the end of the year. The remaining inventory would be valued at $92,934.78 (150,000 X $0.62) and the cost of goods sold throughout the year would be $619,565.20 (1,000,000 X $0.62). If Candy Inc. sold each lollipop at $1.25 the net income for 2008 would be $630,434.80 ($1,250,000 - $619,565.20).
The First-in, first out (FIFO) method is slightly more complicated than the weighted average. Despite the way inventory flows in and out of a company the value assigned to the cost of goods sold and current inventory would be based on first products in would be the cost assigned to first products out the door. In the Candy Inc. example, 1.15MM lollipops were purchase throughout the year at varying prices and 1MM were sold. The cost of goods sold for the year is $562,500 (300,000 X $0.25, 250,000 X $0.50, 350,000 X $0.75, 150,000 X $1.00). The remaining inventory is $150,000 (150,000 X $1.00). If Candy Inc. sold each lollipop at $1.25 the net income under the FIFO cost assumption would be $687,500.00 ($1,250,000 - $562,500).
Last-in, first out (LIFO) is the opposite of FIFO. The inventory values assigned to the cost of goods sold and the current inventory are based on the last items purchased are assigned to the cost of goods sold. The remaining inventory is then based on the cost of those products purchased earlier in the year. In the Candy Inc. example, 1.15MM lollipops were purchase throughout the year at varying prices and 1MM were sold. The cost of goods sold for the year is $675,000 (150,000 X $0.25, 250,000 X $0.50, 350,000 X $0.75, 250,000 X $1.00). The remaining inventory is $37,500 (150,000 X $0.25). If Candy Inc. sold each lollipop at $1.25 the net income under the LIFO cost assumption would be $575,000.00 ($1,250,000 - $675,000).
As you can see each of the different inventory cost flow assumptions greatly impacts the net income and current inventory values. In our example, Candy Inc’s net income was $630,434.80 under the weighted average method, $687,500.00 under FIFO and $575,000.0 under LIFO. The current inventory that makes up part of current assets was $92,934.78 under the weighted average method, $150,000 under FIFO and $37,500.0 under LIFO. Manipulation of current assets and net income would be easy if companies used different methods depending on the economic climate, therefore it is important to be consistent so users of financial accounting may accurately assess trends over time.