Chapter 4: Inventory Costing Under a Perpetual System

Key Inventory Cost Flow Methods: 1. Specific Identification: o Each specific item sold is matched to its exact cost. This method is typically used for unique or high-value items (e.g., cars, jewelry). 2. First-In, First-Out (FIFO): o Assumes the oldest costs (first purchased) are assigned to COGS first. o Example: If one unit is sold after three purchases of $45, $65, and $70, the $45 cost (from May 1) is assigned to COGS. The remaining units ($65 and $70) are reported in inventory on the balance sheet. o FIFO often results in lower COGS and higher gross profit during periods of rising prices because older, cheaper inventory costs are matched with sales. 3. Last-In, First-Out (LIFO): o Assumes the newest costs (last purchased) are assigned to COGS first. o Example: The $70 cost (from May 6) is assigned to COGS, with the remaining units ($45 and $65) in inventory. o LIFO typically results in higher COGS and lower gross profit during periods of rising prices since the most recent, higher-cost inventory is expensed first. 4. Weighted Average: o Assumes costs are averaged across all units available for sale, regardless of purchase date. o Example: The average cost of the three units is $60 (calculated as ($45 + $65 + $70)/3). One unit’s cost of $60 is assigned to COGS, and the remaining units (valued at $120 total) are reported in inventory. o This method smooths out price fluctuations, offering a middle-ground effect on gross profit and inventory values. Impact on Financial Statements: • The cost flow method chosen affects both the gross profit and the inventory valuation. For example, in Exhibit 5.2, the gross profit on the sale ($100 sale price minus COGS) varies depending on which method is used: o FIFO: COGS is $45, resulting in a gross profit of $55. o LIFO: COGS is $70, resulting in a gross profit of $30. o Weighted Average: COGS is $60, resulting in a gross profit of $40.