At the beginning of the current period, a company carried 750 units of its product with a unit cost of $29. A summary of purchases during the current period follows. Also, during the current period, the company sold 2,675 units.
| 1. In general, explain if inventory costs are rising, which inventory costing method—first-in, first-out; last-in, first-out; or average cost—yields the (a) lowest ending inventory? (b) lowest net income? (c) largest ending inventory? (d) largest net income? (e) greatest cash flow, assuming the same method is used for tax purposes? | |||||
| 2. Assume that the company in this example uses the first-in, first-out method. Compute both cost of goods sold for the current period and the ending inventory balance. Use the financial statement effects template to record cost of goods sold for the period. | |||||
| 3. Assume that the company in this example uses the last-in, first-out method. Compute both cost of goods sold for the current period and the ending inventory balance. | |||||
| 4. Assume that the company in this example uses the average cost method. Compute both cost of goods sold for the current period and the ending inventory balance. | |||||
| Units | Unit Cost | Cost | |||
| Beginning Inventory | 750 | 29.00 | 21,750 | ||
| Purchases | |||||
| #1 | 1,425 | 28.00 | 39,900 | ||
| #2 | 795 | 34.00 | 27,030 | ||
| #3 | 900 | 32.50 | 29,250 | ||
| #4 | 1,240 | 30.50 | 37,820 | ||
Inventory costing methods play a significant role in determining a company’s financial statements, profitability, and tax implications. The three primary inventory costing methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the Average Cost method. Let’s explore how these methods impact various financial aspects based on the provided data.
Lowest Ending Inventory: The FIFO method generally yields the lowest ending inventory when costs are rising. This is because it assumes that the earliest acquired (and likely lower-cost) inventory items are sold first, leaving higher-cost items in ending inventory.
Lowest Net Income: LIFO typically results in the lowest net income when inventory costs are rising. This is due to the fact that higher-cost items are considered as being sold first, leading to higher cost of goods sold and consequently lower reported income.
Largest Ending Inventory: In a rising cost scenario, the LIFO method tends to yield the largest ending inventory. This is because lower-cost items are matched with recent revenues, leaving higher-cost items unsold in inventory.
Largest Net Income: Conversely, when inventory costs are rising, FIFO generally results in the largest net income. This is because lower-cost items are recognized as expenses, leading to a lower cost of goods sold and higher reported income.
Greatest Cash Flow for Tax Purposes: In terms of cash flow for tax purposes, LIFO often provides the advantage during times of rising costs. This is because higher costs are matched with revenues, leading to lower taxable income and thus, lower tax payments.
Under the FIFO method, the cost of goods sold (COGS) is calculated by assuming that the oldest inventory is sold first. The ending inventory is valued based on the most recently purchased items. Using this method with the provided data: COGS = Beginning Inventory Cost + Cost of Purchases – Ending Inventory Cost = $21,750 + $96,100 – $37,820 = $80,030
Ending Inventory Balance = Cost of Last Purchase + (Remaining Units × Unit Cost) = $37,820 + (900 × $32.50) = $67,570
With LIFO, the newest inventory is assumed to be sold first. The ending inventory is composed of the earliest purchases. Using the provided data: COGS = Beginning Inventory Cost + Cost of Purchases – Ending Inventory Cost = $21,750 + $96,100 – $21,750 = $96,100
Ending Inventory Balance = Beginning Inventory Cost + Remaining Units × Unit Cost = $21,750 + (750 × $29) = $44,250
Under the Average Cost method, the weighted average unit cost is used to determine COGS and ending inventory. Average Unit Cost = (Total Cost of Beginning Inventory + Total Cost of Purchases) / (Total Units) = ($21,750 + $96,100) / (750 + 1,425 + 795 + 900 + 1,240) = $117,850 / 5,110 ≈ $23.10
COGS = Average Unit Cost × Units Sold = $23.10 × 2,675 ≈ $61,992.50
Ending Inventory Balance = Average Unit Cost × Remaining Units = $23.10 × 750 = $17,325
In conclusion, the choice of inventory costing method significantly affects a company’s financial statements and profitability. During rising inventory costs, FIFO generally yields the lowest net income, while LIFO leads to lower taxable income for tax purposes. The provided data showcases the calculations for COGS and ending inventory balances under each method, providing a comprehensive understanding of their financial impacts.
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