After companies determine the quantity of units of inventory, they apply unit costs to the quantities to compute the total cost of the inventory and cost of goods sold. If companies can particularly identify which particular units are sold and which are still in ending inventory, they can use the specific Identification Method of inventory costing. Using this method, companies can accurately determine ending inventory and cost of goods sold. It requires that companies keep records of the original cost of each individual inventory item. Traditionally specific identification was used to keep records of products such as cars, pianos or other expensive items from the time of purchase until the time of sale much like bar codes used today. This practice nowadays is somewhat rare with most companies engaging into cost flow assumptions.
Cost flow assumptions differ from specific identification in that they assume flows of costs that may be unrelated to the physical flow of goods. There are three assumed methods including (FIFO), (LIFO), and (Average-Cost). Company management usually selects the most appropriate cost flow method.
The (FIFO) first in, first out method assumes the earliest goods purchased are the first to be sold. It often parallels the physical flow of merchandise. Therefore the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. Ending inventory is based on the prices of the most recent units purchased. Companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory cost. To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising, companies tend to prefer to use FIFO because it results in higher net income. A major advantage of the FIFO method is that it in a period of inflation, the costs allocated to ending inventory will approximate their current cost.
The (LIFO) last in, first out method assumes the latest goods purchased are the first to be sold. LIFO never coincides with the actual physical flow of inventory. The costs of the latest goods purchased are the first to be recognized in determining costs of goods sold. Ending inventory is based on prices of the oldest units purchased. Companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory cost.
The average cost method allocates the cost of goods available for sale on the basis of the weighted average unit cost incurred; it also assumes that goods are similar in nature. The company applies the weighted average unit cost to the units on hand to determine the cost of the ending inventory. You can verify the cost of goods sold under this method by multiplying the units sold by the weighted average unit cost.
Each of the three assumed cost flow methods is acceptable for use. 44 % of major U.S companies use the FIFO method. They include companies like Reebok International Ltd. and Wendy’s International. 33% use the LIFO method including companies such as Campbell Soup Company, Kroger’s, and Walgreen Drugs. 19% use the Average Cost method including Starbucks and Motorola. Some companies may use more than one. Black and Decker Manufacturing Company use LIFO for domestic inventories and FIFO for foreign inventories. The reason companies use adopt different inventory cost flow methods are varied but they usually involve three factors. First the income statement effects second the balance sheet effects and last the tax effects.
Whatever cost flow method a company chooses to use, they should use it consistently from one accounting principle to another. This approach is often referred to as the consistency principle, which means that a company uses the same accounting principle and methods from year to year. Consistency enhances the comparability of financial statements over time periods. Using the FIFO one year and LIFO the next would make it difficult to compare the net incomes of the two years.