CHAPTER 11

INVENTORY COST FLOW

TECHNICAL KNOWLEDGE

To identify the cost formulas required by IFRS.

To apply the FIFO costformula.

To apply the weighted average costformula.

To apply the moving averge cost formula.

To apply the specific identification method.

Cost formulas
PAS 2, paragraph 25, expressly provides that the inventories shall
be determined by using either:

a. First in, First out

b. Weighted average

The standard does not permit anymore the use of the in, first out
(LIFO) as an alternative formula in measuring cost of inventories.

First in, First out (FIFO)

The FIFO method assumes that "the goods first purchased are first sold" and
consequently the goods remaining in the inventory at the end of the period
are those most recently purchased or produced.

In other words, the FIFO is in accordance with the ordinary merchandising

procedure that the goods are sold in the order they are purchased.

The rule is "first come, first sold”

The inventory is thus expressed in terms of recent or new prices while the
cost of goods sold is representative of earlier or old prices.
This method favors the statement of financial position in that the inventory
is stated at stated at current replacement cost.
The objection to the method is that there is improper matching of cost
against revenue because the goods sold are stated at earlier or older prices
resulting in understatement of cost of sales.
Accordingly, in a period of inflation or rising prices, the FIFO method
would result to the highest net income.

However, in a period of deflation or declining prices, the FIFO method

would result to the lowest net income.
 Illustration FIFO

Sales
Units Units Cost Total cost
( in units)

Jan. 1 Beginning Balance 800 200 160,00

8 Sale 500

18 Purchase 700 210 147,000

22 Sale 800

31 Purchase 500 220 110,000

The following data pertain to an inventory item:

The ending inventory is 700 units.

Units Unit Cost Total Cost

From Jan. 18 Purchase 200 210 42,000
From Jan. 31 Purchase 500 220 110,00
700 152,00
FIFO - Periodic

Cost of Goods sold

Inventory – January 1 160,000

Purchases (147,000 + 110,000) 257,000
Goods available for sale 417,000
Inventory – January 31 (152,000)
Cost of goods sold 265,000
FIFO - Perpetual
This requires the preparation of stock card.

Purchases Sales Balance

Date Units Unit Total Units Unit Total Units Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 800 200 160,000
8 500 200 100,00 300 200 60,000
0
18 700 210 147,000 300 200 60,000
700 210 147,000
22 300 200 60,000
500 210 105,00 200 210 42,000
0
31 500 220 110,000 200 210 42,000
500 220 110,000
NOTA BENE
Note well that under FIFO-periodic and inventory costs are the same, the inventory
costs are the same. In both cases, the January 31 inventory is PI 52,000.
The cost of goods sold is determined from the stock card as follows:
January 8 sale 100,000

22 sale (60,000+ 105,000) 165,000

Cost of goods sold 265,000

Weighted average - Periodic

The cost of the beginning inventory plus the total cost of purchases during the
period is divided by the total units purchased plus those in the beginning inventory
to get a weighted average unit cost.
Such weighted average unit cost is then multiplied by the units on hand derive the
inventory value.
In other words, the average unit cost is computed by dividing the total cost of
goods available for sale by the total number of units available for sale.

The preceding illustrative data are used.

Units Unit Cost Total Cost
Jan. 1 Beginning balance 800 200 160,000
18 Purchase 700 210 147,000
31 Purchase 500 220 110,000
Total Goods available for sale 2,000 417,000

Weighted average unit cost (417,000/2,000)

Inventory cost (700 x 208.50)

Cost of goods sold

Inventory – January 1 160,000
Purchases 257,000
Goods available for sale 417,000
Inventory – January 31 (145,950)
Cost of goods sold 271,050
Weighted average - Perpetual
When used in conjunction with the perpetual system, the weighted average method
is popularly known as the moving average method.
PAS 2, paragraph 27, provides that the weighted average may be calculated on a
periodic basis or as each additional shipment is received depending upon the
circumstances of the entity.
Under this method, a new weighted average unit cost must be computed after every
purchase and purchase return.
Thus, the total cost of goods available after every purchase and purchase return is
divided by the total units available for sale at this time to get a new weighted
average unit cost.
Such new weighted average unit cost is then multiplied by the units on hand to get
the inventory cost.
This method requires the keeping of inventory stock card in order to monitor the
"moving' unit cost after every purchase.

Units Unit Total cost

cost
January 1 Balance 800 200 160,000
8 Sale (500) 200 (100,000)
Balance 300 200 60,000
18 Purchase 700 210 147,000
Total 1,000 207 207,000
22 Sale (800) 207 (165,600)
Balance 200 207 41,400
31 Purchase 500 220 110,000
Total 700 216 151,400

Observe that a new weighted average unit cost is computed after every purchase.
Thus, after January 18 purchase, the total cost of P207,000 is divided by 1,000
units to get a weighted average unit cost of P207.
After the January 31 purchase, the total cost of P151, 400 is divided by 700 units to
get a new weighted average unit cost of P216.
Cost of goods sold from the stock card

January 8 Sale 100,000

22 Sale 165,600
Cost of goods sold 265,600

The argument for the weighted average method is that it is relatively easy to apply,
especially the weighted average method produces inventory valuation that
approximates current value if there is a rapid turnover of inventory.

The argument against the weighted average method is that there may be a
considerable lag between the current cost and inventory valuation since the average
unit cost involves early purchases.

Last in, First out (LIFO)

'Ihe LIFO method assumes that "the goods last purchased are first sold" and
consequently the goods remaining in the inventory at the end of the period are
those first purchased or produced.
The inventory is thus in terms of earlier or old prices and the cost of goods sold is
representative of recent or new prices.
The LIFO favors the income statement because there is matching of current cost
against current revenue, the cost of goods sold being expressed in terms of current
or recent cost.
The objection of the LIFO is that the inventory is stated at earlier or older prices
and therefore there may be a significant lag between inventory valuation and
current replacement cost.
Moreover, the use of LIFO permits income manipulation, such as by making year-
end purchases designed to preserve existing inventory layers. At times these
purchases may not even be in the best economic interest of the entity.
Actually, in a period of rising prices, the LIFO method would result to the lowest
net income.In a period of declining prices the LIFO method would result to the
highest net income.
LIFO - Periodic
In the preceding illustration, the cost of 700 units under the LIFO is computed as follows:

Units Unit cost Total cost

From January 1 balance 700 200 140,000

Cost of goods sold under LIFO – periodic

Inventory – January 1 160,000
Purchases 257,000
Goods available for sale 417,000
Inventory – January 31 (140,000)
Cost of goods sold 227,000

LIFO – Perpetual
This requires the preparation of stock card.
Purchases Sales Balance
Date Units Unit Total Units Unit Total Units Unit Total
cost cost cost cost cost cost
Jan. 1 800 200 160,000
8 500 200 100,000 300 200 60,000
18 700 210 147,000 300 200 60,000
700 210 147,000
22 700 210 147,000
100 200 20,000 200 200 40,000
31 500 220 110,000 200 200 40,000
500 220 110,00

Note well that LIFO-periodic and LIFO-perpetual differ in inventory value.

Under LIFO periodic, the January 31 inventory is P140,000 and under LIFO
perpetual, the January 31 inventory is P150,000.
Another Illustration
Units Unit cost Total cost
Jan. 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
15 Sale (7,000)
16 Sale return 1,000
30 Purchase 16,000 150 2,400,000
31 Purchase return (2,000) 150 300,000
Ending balance 18,000
FIFO -whether periodic or perpetual
Units Unit cost Total cost
Jan. 10 Purchase 4,000 250 1,000,000
30 Purchase 14,000 150 2,100,000
18,000 3,100,000

The January 30 purchase of 16,000 units is reduced by the purchase return of 2,000 units or net purchase of
14,000 units. Note that under FIFO perpetual, the sale return of 1,000 units on January 16 would be costed
back to inventory at the latest purchase unit cost of P250 before the sale.

Moving average — Perpetual

Units Unit cost Total cost
Jan. 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
Balance 10,000 225 2,250,000
15 Sale (7,000) 225 (1,575,000)
Balance 3,000 225 675,000
16 Sale return 1,000 225 225,000
Balance 4,000 225 900,000
30 Purchase 16,000 150 2,400,000

Balance 20,000 165 3,300,000

31 Purchase return (2,000) 150 (300,000)
Balance 18,000 167 3,000,000

Observe that the moving average unit cost changes every time there is a new purchase or a purchase
return. The moving average unit cost is not affected by a sale or a sale return.
Weighted average - Periodic

Units Unit cost Total cost

Jan. 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
30 Purchase 16,000 150 2,400,000
31 Purchase return (2,000) 150 (300,000)
24,000 4,350,000

Weighted average unit cost (P4,350,000 / 24,000 units) 181.25

Cost of ending inventory (18,000 x 181.25) 3,262,500

Specific identification
Specific identification means that specific costs are attributed identified items of
inventory.
The cost of the inventory is determined by simply multiplying units on hand by
their actual unit cost.
This requires records which will clearly determine the actual costs of goods on
hand.

PAS 2, paragraph 23, provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.

The specific identification method may be used in either periodic or perpetual

inventory system,

The major argument for this method is that the flow of the inventory cost
corresponds with the actual physical flow of goods.

With specific identification, there is an actual determination of units sold and on

hand.

The major argument against this method is that it is very costly to implement even
with high-speed computers.
With specific identification, there is an actual determination of cost of units sold and on
hand.
Standard costs
Standard costs are predetermined product costa established on the basis of normal levels of
materials and supplies, labor, efficiency and capacity utilization„

Observe that a standard cost is predetermined and, once determined, is applied to all
inventory movement8 inventories, goods available for sale, purchases and goods sold or
placed in production.

PAS 2, paragraph 21, states that the standard cost method may be used for convenience if
the results approximate cost.

However, the standards set should be realistically attainable and are reviewed and revised
regularly in the light of current conditions.

Standard coating is taken up in a higher accounting course and is not discussed further in
this book.

Relative sales price method

When different commodities are purchased at a lump sum, the single cost is apportioned
among the commodities based on their respective sales price. This is based on the
philosophy that cost is proportionate to selling price.
For example, products A, B, and C are purchased at “ basket price" of P3,000,000. Assume
that the said products have the following sales price: A:P500,000, B P1,500,000, and C
P3,000,000.

Computation of cost of each product

Product A 500,000 5/50 x 3,000,000 300,000
Product B 1,500,000 15/50 x 3,000,0000 900,000
Product C 3,000,000 30/50 x 3,000,000 1,800,000
5,000,000 3,000,000