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Perpetual inventory system updates inventory accounts after each purchase or sale.
"Purchases" account is updated continuously, however, "Inventory" account is updated on a periodic ba
end of each accounting period (e.g., monthly, quarterly)
Inventory subsidiary ledger is not updated after each purchase or sale of inventory.
Inventory quantities are not updated continuously.
Inventory quantities are updated on a periodic basis.
Example 1 (Company A)
[Checking]
Quantity of ending inventory
= Beginning inventory + Units purchased - Units sold
= 700 + 900 - 1,000 = 600 units
[Checking]
Quantity of ending inventory
= Beginning inventory + Units purchased - Units sold
= 700 + 900 - 1,000 = 600 units
Using FIFO, units purchased first are assumed to be sold first.
1,000 units sold
= 700 units from beginning inventory of at $10 unit cost
+ 100 units from May 3 purchases at $12 unit cost
+ 200 units from May 15 purchases at $14 unit cost
Using LIFO, units purchased last are assumed to be sold first.
1,000 units sold
= 200 units from May 19 purchases at $15 unit cost
+ 600 units from May 15 purchases at $14 unit cost
+ 100 units from May 3 purchases at $12 unit cost
+ 100 units from beginning inventory at $10 unit cost
Mov
Inventory
Date Transactions Units Sold Unit Cost Aver
Units
Unit C
May 1 Beginning Inventory 700 $10 700 $1
$10.25
May 3 Purchase 100 $12 800
)
May 8 Sale (500) ?? 300 $10.
$12.75
May 15 Purchase 600 $14 900
)
$13.16
May 19 Purchase 200 $15 1,100
)
May 25 Sale (400) ?? 700 70
May 27 Sale (100) ?? 600 60
May 31 Ending Inventory ??
(*1) Average cost of 800 units
= (700x$10 + 100x$12) / (700 + 100)
= ($7,000 + $1,200) / 800 = $8,200 / 800 = $10.25
[Checking]
Quantity of ending inventory
= Beginning inventory + Units purchased - Units sold
= 700 + 900 - 1,000 = 600 units
[Checking]
The Delta company sold 1,400 units during the month of July.
Required: Compute inventory on July 31, 2016 and cost of goods sold for the month
of July using following inventory costing methods:
Solution:
Number of units in ending inventory:
Ending inventory = Beginning inventory + Purchases made during the month – Units
sold during the month
= 500 units + *1,500 units – 1,400 units
= 600 units
b. Computation of cost of goods sold (COGS) for July 31, 2016 under FIFO:
Alternatively, we can compute cost of goods sold (COGS) using earliest cost method
as follows:
Alternatively, we can compute cost of goods sold (COGS) using most recent cost
method as follows:
(3) If average cost method is used:
[(500 units × $20) + (800 units × $24) + (700 units × $26)]/500 units + 800 units +
700 units
= $47,400/2,000 units
= $23.70
b. Computation of cost of goods sold (COGS) for July 31, 2016 under average
cost method:
Cost of goods sold (COGS) = Cost of goods available for sale – Ending inventory
Cost of goods sold (COGS) = [{(500 units × $20) + (800 units × $24) + (700 units ×
$26)} – $14,220*]
= $47,400 – $14,220
= $33,180
Inventory Methods for Ending Inventory and
Cost of Goods Sold
Cost of goods sold and Inventory
Remember, cost of goods sold is the cost to the seller of the goods sold to customers.
Cost of Goods Sold is an EXPENSE item. Even though we do not see the word Expense
this in fact is an expense item found on the Income Statement as a reduction to
Revenue. For a merchandising company, the cost of goods sold can be relatively large. All
merchandising companies have a quantity of goods on hand called merchandise inventory
to sell to customers. Merchandise inventory (or inventory) is the quantity of goods
available for sale at any given time.
You will now learn how to calculate the Cost of Goods Sold using 4 different methods.
FIFO (First in, First out) – this means you will use the OLDEST inventory first to fill
orders. This also means the oldest costs will appear in Cost of Goods Sold (since
this is an Expense account this also means oldest costs will appear in the Income
Statement). The most recent costs are shown in the Inventory asset account
balances and are provided on the Balance Sheet. This is an advantage because you
are now reporting Inventory at the current cost which better reflects what it would
cost to replace inventory if that would become necessary due to a disaster. FIFO
shows the actual flow of goods…typically you will sell the oldest inventory before the
newest inventory.
LIFO (Last in, First out) – this means you will use the MOST RECENT inventory
first to fill orders. Cost of goods sold will reflect the current or most recent costs and
are a better representation of matching since you are matching revenue will current
costs of the inventory. The Balance Sheet will show inventory at the oldest inventory
costs and may not represent current market value.
Weighted Average (also called Average Cost) – this method is best used when
the prices change from purchase to purchase and you want consistency. The
weighted average method smooths out price changes so you have a steady stream
of cost instead of sharp increases and decreases. You will calculate a new Average
Cost after each Purchase (Sales will not change the average cost).
Specific Identification – clearly, this will be your favorite method…it is the easiest
to calculate in our examples because it specifically tells you which purchases
inventory comes from. This is most often used for high priced inventory – think car
sales for example. When a car dealership purchases a blue BMW convertible for
$20,000 and later sells it for $60,000…they will want to show the exact cost of the
BMW it sold as opposed to the cost of another car. So, specific identification exactly
matches the costs of the inventory with the revenue it creates.
Okay, enough theory – how do these calculations work exactly? There are a couple of ways
you can do them – there is an Inventory Record or a shortcut calculation. You will see both
because they are both beneficial. Most computer systems will show you the Inventory
Record form so you need to understand how to read it. However, it can be time consuming
and not practical for homework and test situations so you learn the alternative method as
well. We will be using the perpetual inventory system in these examples which
constantly updates the inventory account balance to reflect inventory on hand. When
calculating the Cost of Goods Sold for a sale, you must IGNORE the selling price. The
selling price has NOTHING to do with the cost. We are trying to determine how much the
items we sold originally COST us – that is the purpose behind cost of goods sold. Next
thing to remember, you can only use items that occurred BEFORE the sale (meaning, you
cannot use a purchase from August 28 when calculating cost of goods sold on August 14 –
why? It hasn’t happened yet). We will pick inventory from the different purchases and use
the purchase price to calculate the cost of goods sold.
Under the FIFO method, we will use the oldest inventory at the time of the sale first. You
must calculate Cost of Goods Sold for each sale individually. Watch this video on the FIFO
Method.
Using the inventory record format, the transactions from the video would look like this under
the FIFO method:
Inventory Balance
Date Goods Purchased Cost of Goods Sold
Total cost of goods sold for January would be $6,850 (3,000 + 3,850). Sales would be Jan 8
Sales ( 300 units x $30) $9,000 + Jan 11 Sales (250 units x $40) $10,000 or $19,000. The
gross profit (or margin) would be $12,150 ($19,000 Sales - 6,850 cost of goods sold). The
journal entries for these transactions would be (assuming all transactions on credit):
Note: No journal entry is prepared for beginning inventory since it is a rollover from last
period's ending balance.
Date Account D
Jan 2 Merchandise Inventory 3,
Accounts Payable
Sales
Merchandise Inventory
Accounts Payable
Sales
Merchandise Inventory
Jan 18 Merchandise Inventory 6,
Accounts Payable
Under the LIFO method, we will use most recent purchases at the time of the sale first.
You must calculate Cost of Goods Sold for each sale individually. Let’s look at the this
video:
Using the inventory record format, the transactions from the video would look like this under
the LIFO method:
Inventory Balanc
Date Goods Purchased Cost of Goods Sold
Total cost of goods sold for the month would be $7,200 (4,000 + 3,200). Since total Sales
would the same as we calculated above Jan 8 Sales ( 300 units x $30) $9,000 + Jan 11
Sales (250 units x $40) $10,000 or $19,000. The gross profit (or margin) would be $11,800
($19,000 Sales - 7,200 cost of goods sold). The journal entries for these transactions would
be would be the same as show above the only thing changing would be the AMOUNT of
cost of goods sold used in the Jan 8 and Jan 15 entries.
The Weighted Average method strives to smooth out price changes during the period. To
do this, we will calculate an average cost of inventory at the end of the month under the
periodic method (perpetual method calculates average cost of inventory after each
purchase). Sales of inventory will not affect the average cost of inventory. It does NOT
matter which purchase the inventory comes from when using the average cost method.
Instead, we will use the average cost calculated to determine cost of goods sold for any
sales transactions. Average Cost is calculated by taking the TOTAL COST of INVENTORY /
TOTAL INVENTORY QUANITY. Let’s look at a video:
The Inventory Record for this information in the video would be:
Purchases Cost of goods sold Inventory Balance
50 units $682.50**
Jan 250 units x $13.67 avg cost =
15 $3,417.50
(take Jan 11 balance - Jan 15 cogs)
**Jan 15 and 16 off a little from the information in the video due to rounding of the average
cost.
Total cost of goods sold for January would be $7,017.50 ($3600 + 3,417.50). Since total
Sales would the same as we calculated before $19,000. The gross profit (or margin) would
be $11,982.50 ($19,000 Sales - 7017.50 cost of goods sold). The journal entries for these
transactions would be would be the same as show above the only thing changing would be
the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.
Specific Identification
Finally, the last method – we are saving the easiest one for last. Specific identification will
tell you exactly which purchase to use when determining cost.
Easy, huh? No guess work, no hard thinking – just take the information given and calculate
based on the purchase prices given. Let's look at another example:
On May 9, you sold 180 units consisting of 80 units from beginning inventory and
100 units from the May 6 purchase.
May 30 sold 300 units consisting of 200 units from the May 6 purchase and 100 units
from the May 25 purchase
Using an Inventory Record, cost of goods sold would look like this:
May
350 x $350 = $122,500
6
80 x $300 = 24,000
May
100 x $350 = 35,000
9
COGS 180 units $ 59,000
May
80 x $450 = $36,000
17
May
100 x $458 = $45,800
25
The total cost of goods sold for May would be $233,800 (59,000 + 174,800).
You will now learn how to calculate the Cost of Goods Sold using 4 different methods.
FIFO (First in, First out) – this means you will use the OLDEST inventory first to fill
orders. This also means the oldest costs will appear in Cost of Goods Sold (since
this is an Expense account this also means oldest costs will appear in the Income
Statement). The most recent costs are shown in the Inventory asset account
balances and are provided on the Balance Sheet. This is an advantage because you
are now reporting Inventory at the current cost which better reflects what it would
cost to replace inventory if that would become necessary due to a disaster. FIFO
shows the actual flow of goods…typically you will sell the oldest inventory before the
newest inventory.
LIFO (Last in, First out) – this means you will use the MOST RECENT inventory
first to fill orders. Cost of goods sold will reflect the current or most recent costs and
are a better representation of matching since you are matching revenue will current
costs of the inventory. The Balance Sheet will show inventory at the oldest inventory
costs and may not represent current market value.
Weighted Average (also called Average Cost) – this method is best used when
the prices change from purchase to purchase and you want consistency. The
weighted average method smooths out price changes so you have a steady stream
of cost instead of sharp increases and decreases. You will calculate a new Average
Cost after each Purchase (Sales will not change the average cost).
Specific Identification – clearly, this will be your favorite method…it is the easiest
to calculate in our examples because it specifically tells you which purchases
inventory comes from. This is most often used for high priced inventory – think car
sales for example. When a car dealership purchases a blue BMW convertible for
$20,000 and later sells it for $60,000…they will want to show the exact cost of the
BMW it sold as opposed to the cost of another car. So, specific identification exactly
matches the costs of the inventory with the revenue it creates.
Okay, enough theory – how do these calculations work exactly? There are a couple of ways
you can do them – there is an Inventory Record or a shortcut calculation. You will see both
because they are both beneficial. Most computer systems will show you the Inventory
Record form so you need to understand how to read it. However, it can be time consuming
and not practical for homework and test situations so you learn the alternative method as
well. We will be using the perpetual inventory system in these examples which
constantly updates the inventory account balance to reflect inventory on hand. When
calculating the Cost of Goods Sold for a sale, you must IGNORE the selling price. The
selling price has NOTHING to do with the cost. We are trying to determine how much the
items we sold originally COST us – that is the purpose behind cost of goods sold. Next
thing to remember, you can only use items that occurred BEFORE the sale (meaning, you
cannot use a purchase from August 28 when calculating cost of goods sold on August 14 –
why? It hasn’t happened yet). We will pick inventory from the different purchases and use
the purchase price to calculate the cost of goods sold.
Under the FIFO method, we will use the oldest inventory at the time of the sale first. You
must calculate Cost of Goods Sold for each sale individually. Watch this video on the FIFO
Method.
Using the inventory record format, the transactions from the video would look like this under
the FIFO method:
Inventory Balance
Date Goods Purchased Cost of Goods Sold
Total cost of goods sold for January would be $6,850 (3,000 + 3,850). Sales would be Jan 8
Sales ( 300 units x $30) $9,000 + Jan 11 Sales (250 units x $40) $10,000 or $19,000. The
gross profit (or margin) would be $12,150 ($19,000 Sales - 6,850 cost of goods sold). The
journal entries for these transactions would be (assuming all transactions on credit):
Note: No journal entry is prepared for beginning inventory since it is a rollover from last
period's ending balance.
Date Account D
Sales
Merchandise Inventory
Accounts Payable
Sales
Merchandise Inventory
Under the LIFO method, we will use most recent purchases at the time of the sale first.
You must calculate Cost of Goods Sold for each sale individually. Let’s look at the this
video:
Using the inventory record format, the transactions from the video would look like this under
the LIFO method:
Inventory Balanc
Date Goods Purchased Cost of Goods Sold
Total cost of goods sold for the month would be $7,200 (4,000 + 3,200). Since total Sales
would the same as we calculated above Jan 8 Sales ( 300 units x $30) $9,000 + Jan 11
Sales (250 units x $40) $10,000 or $19,000. The gross profit (or margin) would be $11,800
($19,000 Sales - 7,200 cost of goods sold). The journal entries for these transactions would
be would be the same as show above the only thing changing would be the AMOUNT of
cost of goods sold used in the Jan 8 and Jan 15 entries.
The Weighted Average method strives to smooth out price changes during the period. To
do this, we will calculate an average cost of inventory at the end of the month under the
periodic method (perpetual method calculates average cost of inventory after each
purchase). Sales of inventory will not affect the average cost of inventory. It does NOT
matter which purchase the inventory comes from when using the average cost method.
Instead, we will use the average cost calculated to determine cost of goods sold for any
sales transactions. Average Cost is calculated by taking the TOTAL COST of INVENTORY /
TOTAL INVENTORY QUANITY. Let’s look at a video:
The Inventory Record for this information in the video would be:
Purchases Cost of goods sold Inventory Balance
50 units $682.50**
Jan 250 units x $13.67 avg cost =
15 $3,417.50
(take Jan 11 balance - Jan 15 cogs)
**Jan 15 and 16 off a little from the information in the video due to rounding of the average
cost.
Total cost of goods sold for January would be $7,017.50 ($3600 + 3,417.50). Since total
Sales would the same as we calculated before $19,000. The gross profit (or margin) would
be $11,982.50 ($19,000 Sales - 7017.50 cost of goods sold). The journal entries for these
transactions would be would be the same as show above the only thing changing would be
the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.
Specific Identification
Finally, the last method – we are saving the easiest one for last. Specific identification will
tell you exactly which purchase to use when determining cost.
Easy, huh? No guess work, no hard thinking – just take the information given and calculate
based on the purchase prices given. Let's look at another example:
On May 9, you sold 180 units consisting of 80 units from beginning inventory and
100 units from the May 6 purchase.
May 30 sold 300 units consisting of 200 units from the May 6 purchase and 100 units
from the May 25 purchase
Using an Inventory Record, cost of goods sold would look like this:
80 x $300 = 24,000
The total cost of goods sold for May would be $233,800 (59,000 + 174,800).
The Delta company uses a periodic inventory system. The beginning balance of
inventory and purchases made by the company during the month of July, 2016 are
given below:
The Delta company sold 1,400 units during the month of July.
Required: Compute inventory on July 31, 2016 and cost of goods sold for the month
of July using following inventory costing methods:
Solution:
Number of units in ending inventory:
Ending inventory = Beginning inventory + Purchases made during the month – Units
sold during the month
= 500 units + *1,500 units – 1,400 units
= 600 units
b. Computation of cost of goods sold (COGS) for July 31, 2016 under FIFO:
Alternatively, we can compute cost of goods sold (COGS) using earliest cost method
as follows:
(2) Last in, first out (LIFO) method:
b. Computation of cost of goods sold (COGS) for July 31, 2016 under LIFO:
Alternatively, we can compute cost of goods sold (COGS) using most recent cost
method as follows:
[(500 units × $20) + (800 units × $24) + (700 units × $26)]/500 units + 800 units +
700 units
= $47,400/2,000 units
= $23.70
Cost of goods sold (COGS) = Cost of goods available for sale – Ending inventory
Cost of goods sold (COGS) = [{(500 units × $20) + (800 units × $24) + (700 units ×
$26)} – $14,220*]
= $47,400 – $14,220
= $33,180
The beginning inventory of Beta Company consisted of 100 units @ $60 each. The
following transactions occurred during the month of March 2013.
Solution:
(1) If perpetual inventory system is used:
March 31 – closing entry to create cost of goods sold account and to update
inventory account :
*140 × $60 = 8,400