Chapter 4: Inventory Costing Illustration

1. Specific Identification (SI): • • Under SI, each item sold is matched with its specific purchase cost. For Trekking, the bikes sold and the remaining inventory are tracked based on actual purchase dates and costs. Example: o The first two columns in Exhibit 5.4 show purchases totaling $5,990. Trekking's internal records show which bikes were sold (10 from August 1, 15 from August 3, 15 from August 17, and 3 from August 28). These sales account for $4,582 in COGS. o The remaining 12 units valued at $1,408 are recorded as Ending Inventory. o COGS: $4,582 o Ending Inventory: $1,408 2. First-In, First-Out (FIFO): • • FIFO assumes that the first units purchased are the first units sold. Example: o Trekking’s August transactions begin with 10 bikes at $91 each. When 20 bikes are sold, the first 10 are sold at $91 each, and the next 10 at $106 each. The remaining 5 units ($106 each) are recorded as inventory. o Then, 20 more bikes are purchased at $115 each, and 10 more at $119 each. When 23 bikes are sold, the first 5 are sold at $106 each, followed by 18 at $115. o The remaining 12 bikes are valued at $1,420 as ending inventory. o COGS: $4,570 o Ending Inventory: $1,420 3. Last-In, First-Out (LIFO): • • LIFO assumes that the most recent purchases are sold first. Example: o When 20 bikes are sold, LIFO assumes 15 from the most recent purchase (at $106 each) and 5 from the earlier purchase (at $91 each) are sold. The remaining 5 units at $91 each stay in inventory. o Next, 20 more bikes are purchased at $115 each, and then 10 more at $119 each. When 23 bikes are sold, LIFO assumes 10 are from the $119 purchase, and 13 from the $115 purchase. o The remaining 12 bikes are valued at $1,260 in ending inventory. o COGS: $4,730 o Ending Inventory: $1,260 4. Weighted Average: • • The Weighted Average method assigns costs based on the average cost per unit of inventory at the time of each sale. Example: o The average cost is calculated after each purchase. Initially, the average is $100 per bike. After selling 20 bikes, the remaining 5 units have an average cost of $100 each. o After the next purchase, the average cost rises to $112. After the following purchase, the average rises again to $114. When 23 bikes are sold, they are valued at the $114 average. o The remaining 12 bikes are valued at $1,368 as ending inventory. o COGS: $4,622 o Ending Inventory: $1,368 Financial Statement Effects: • • Rising Costs: o Under FIFO, the oldest and typically lower costs are used for COGS, resulting in the highest gross profit. o Under LIFO, the most recent, higher costs are used for COGS, leading to the lowest gross profit. o Weighted Average produces results between FIFO and LIFO. Falling Costs: o The effects are reversed: FIFO gives the highest COGS and the lowest gross profit, while LIFO gives the lowest COGS and the highest gross profit. Tax Implications: • LIFO often provides a tax advantage by reporting lower net income (due to higher COGS) when prices are rising, reducing taxable income. However, under the LIFO conformity rule, if a company uses LIFO for tax purposes, it must also use it for financial reporting. Example Application: If Trekking expects continued rising costs, using LIFO may reduce taxable income and provide a temporary tax benefit. However, this will lower gross profit and might affect performance-based bonuses. FIFO, on the other hand, results in higher gross profit and net income but leads to higher taxes during inflationary periods.