Accounting for Inventories

Lower of cost or market (LCM) rule; inventory cost flow methods (specific identification, first in first out (FIFO), last in first out (LIFO), weighted average); cost flow and physical flow of inventory.

1. Introduction to inventory cost flow methods

Previously when we talked about inventory, we assumed that inventory costs did not change. However, in reality inventory purchase prices fluctuate and that results in varying inventory costs. That is why there is a question of which cost to allocate to the cost of goods sold and the ending inventory at period end.

There are four inventory cost flow methods. The four methods are listed below:

  1. Specific identification
  2. First-in, first-out (FIFO)
  3. Last-in, first-out (LIFO)
  4. Weighted-average

1.1. Specific identification cost flow method

Companies producing or trading in easily identifiable inventories use the method of specific identification. Cars, airplanes and ships can serve as examples. Each item of inventory is marked, tagged or coded with its "specific" unit cost. This method allows costing of inventory based on its actual physical flow.

Specific identification is an actual physical flow inventory costing method in which items still in inventory are specifically cost to arrive at the total cost of the ending inventory.

This method is difficult to apply by companies that have massive inventory volumes with low unit costs. For instance, it will be hard for a grocery store to keep track of soup cans acquired at different costs. Therefore, grocery stores and similar entities do not apply the method of specific identification.

There is one aspect of the specific identification method that should be mentioned. Management can manipulate the cost of goods sold by selecting which cost will be used in a particular sale transaction. For example, suppose a dealership sells cars. One day the dealership has two identical cars on sale, a Ford costing $5,000 (that was purchased by the company first) and a Ford costing $5,500 (that was acquired by the company after the first Ford). A customer does not care which Ford to get as long as both Fords are identical. However, if the company wants to increase the cost of goods sold (respectively, decrease income), management may sell the $5,500 Ford; if visa versa, then management may sell the $5,000 Ford. So, because the two Fords are identical in physical characteristics and selling price, the customer does not see a difference between the two Fords. However, the dealership may use this to their advantage and manipulate financial statements numbers.

1.2. First-in, first-out (FIFO) cost flow method

The method of first-in, first-out requires that the cost of items purchased first be assigned to the cost of goods sold first.

First-in, first-out (FIFO) inventory costing method assumes that the costs of earliest inventories acquired are the first to be recognized as the cost of goods sold.

In the preceding example, the cost of $5,000 Ford will be assigned to the cost of goods sold.

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