Periodic Inventory
Periodic Inventory Valuation
There are several ways to value inventory. In this activity, we will evaluate how to assign appropriate costs to inventory.
In a periodic inventory system of valuation, a physical count of inventory is taken at the end of the fiscal year to determine how many units make up ending inventory. Throughout the year, the inventory amount is often estimated, because it is expensive and difficult to do a physical count, except at year end, when it's required.
The CICA Handbook says inventory should have a cost that
represents the "fairest matching of costs against revenue".
There are a few options available to companies so that they can figure out the value of the inventory that they have at the end of a period. If a business only sold one thing, and it always cost the same, it would be easy! The problem is, most businesses sell a variety of items, and the cost of those items is often different at the end of the year than the beginning. That makes inventory valuation a real challenge.
Options for the Valuation of Inventory
A: SPECIFIC IDENTIFICATION
Each item is matched with its actual cost. This is usually used with expensive or unique items. Companies that use this method sell a fairly low variety of items and can identify each one easily, either because it's unique, or it may have a serial number. Some examples might be cars, art, electronics, etc. If a business can use this method, it is easy to record the cost of it, while it's in inventory and when it's sold. When inventory costs are rising, a company can take advantage of this method by selling off the cheapest inventory to show a high net income (low cost of goods sold).
B: ACTUAL FLOW OF GOODS
The methods that come under this category are far more common. In these methods, inventory is valued based on the sequence in which goods are sold. This strongly depends on the operations of the specific company.
To illustrate the use of the following methods, we will use the following situation:
Athabasca Company uses a periodic inventory system. Its records show the following for the year 2005, in which 80 units were sold:
Units / Unit Cost / Total CostJanuary 1 / Beginning Inventory / 40 / $8 / $320
June 12 / Purchases / 25 / $9 / $225
November 28 / Purchases / 30 / $10 / $300
95 / $845
I. First In, First Out (FIFO) Assumption - goods that are purchased first, are sold first. This method looks like a conveyor belt. Perishables are this kind of good.
We can calculate both the Cost of Goods Sold and the Ending Inventory, with the information provided.
To calculate the cost of goods sold for Athabasca company using FIFO, we know that we have sold 80 units in the period. The cost of the first 80 units we purchased, or had in inventory, will be the cost of the units we've sold. In this case, that would be the opening inventory (40 units) plus the April 13 purchase (25 units) and part of the April 28 purchase (15 units), to make up our 80 sold. To calculate the Cost of Goods Sold, it's easier to use a table:
Cost of Goods Sold =
Units / Unit Cost / Total Cost40 / $8 / $320
25 / $9 / $225
15 / $10 / $150
80 / $695
Therefore, the total cost of the 80 units that were sold was valued at $695.
The other number we can get from this information is the Ending Inventory. If we sold the first 80 units, we must have the last 15 leftover as Ending Inventory. In this case, all 15 units would be from the April 28 purchase.
Ending Inventory =
Units / Unit Cost / Total Cost15 / $10 / $150
Therefore, the Ending Inventory is valued at $150.
**NOTE** Cost of Goods Sold + Ending Inventory = Beginning Inventory + Purchases
II.Last In, First Out (LIFO) Assumption - The last goods purchased are sold first, much like this pile of logs. The last logs purchased will be on top, and will be sold first. This method is suitable if the company has a similar flow of goods.
We can again calculate both the Cost of Goods Sold and the Ending Inventory, with the information provided.
To calculate the Cost of Goods Sold for Athabasca company using LIFO, we know that we have sold 80 units in the period. The cost of the last 80 units we purchased, or had in inventory, will be the cost of the units we've sold. In this case, that would be the April 28 purchase (30 units), the April 13 purchase (25 units), and part of the opening inventory (25 units), to make up our 80 sold. To calculate the cost of goods sold, we'll use the same kind of table:
Cost of Goods Sold =
Units / Unit Cost / Total Cost30 / $10 / $300
25 / $9 / $225
25 / $8 / $200
80 / $725
Therefore, the total cost of the 80 units that were sold was valued at $725.
We will also calculate the Ending Inventory. If we sold the last 80 units, we must have the last 15 leftover as ending inventory. In this case, all 15 units would be from the beginning inventory.
Ending inventory =
Units / Unit Cost / Total Cost15 / $8 / $120
Therefore, the Ending Inventory is valued at $120.
III. Average Cost Method - When inventory is mixed together when it comes in, an average of the costs over the period can be used to value inventory. It may be very hard to tell which piece of inventory is which, and which will be sold first. That is when this method is most appropriate.
We can calculate both the Cost of Goods Sold and the ending inventory, with the information provided.
To calculate the Cost of Goods Sold for Athabasca Company using the average cost method, we must come up with an average cost per unit of our inventory. To do that, we use the formula:
Average Cost per Unit = Total Cost of Inventory / Number of Units in Inventory
For Athabasca Company, that would be:
Average Cost per Unit = 845 / 95 = $8.89 per unit
To calculate the Cost of Good Sold, we use the formula:
Cost of Goods Sold = Number of Units Sold x Average Cost per Unit
For Athabasca Company, that would be:
Cost of Goods Sold = 80 X 8.89 = $711.20
The other number we can get from this information is the Ending Inventory. The formula used to calculate ending inventory is:
Ending Inventory = Number of Units in Inventory x Average Cost per Unit
For Athabasca Company, that would be:
Ending Inventory = 15 x 8.89 = $133.35
In Canada, FIFO is the most popular method of inventory valuation. LIFO is not allowed because of Income Tax regulations, but is occasionally used for business analysis. We will outline why it can be a problem when we look at the effect of each method on the Income Statement.
As always, CONSISTENCY is the key; from year to year, inventory valuation will most likely be the same, BUT if the nature of the business changes and the inventory system is no long suitable, any changes made should be reflected in the notes to the financial statements.
GAAP permits that the assumed flow of goods can be different from the actual flow of goods.
Related Journal Entries
No matter which method you choose, the journal entries for the periodic inventory system will remain constant.
For the purchase of new inventory, the journal entry is:
Date / Purchases / XXXXBank (or Accounts Payable) / XXXX
To record the purchase of inventory
For a sale, the journal entry is:
Date / Cash or (Accounts Receivable) / XXXXSales / XXXX
To record a sale
The inventory is adjusted when we close the books at the end of the accounting period.
Review Questions
- Stella’s Used Cars sells a variety of makes and models. Her beginning inventory on June 1, 2010 was:
Make/Model / Colour / Cost
1999 Toyota Corolla / Green / $10,150
1975 Mustang / Red / $14,000
1998 Ford Explorer / Blue / $5,000
- During the month of June, Stella’s Used Cars purchased the following cars:
Make/Model / Colour / Cost
2003 Ford Tracker / Silver / $7,000
2001 Chevrolet Malibu / Red / $9,500
- Before June 30th, Stella’s Used Cars sold the Ford Explorer and the Chevrolet Malibu.
- Determine the Cost of Goods Sold and Ending Inventory for Stella’s Used Cars for the month of June, using the specific identification method.
Question #1: Answer
Cost of Goods Sold = Cost of the Ford Explorer + Cost of the Chevrolet Malibu = 5,000 +9,500 = $14,500
Ending Inventory = Cost of all of the other cars on the lot = 10,150+14,000+7,000= $31,150
Question #2
- Rusty Company had the following records on a product called the awesome, for 2009.
Units / Unit Cost
January 1 / Beginning Inventory / 100 / $20
April 25 / Purchase / 200 / $26
July 26 / Purchase / 300 / $28
October 3 / Purchase / 250 / $30
- By the year end, Rusty company had sold 670 awesomes.
- a) Calculate the Cost of Goods Sold and Ending Inventory, using the FIFO method of Inventory Valuation.
- b) Calculate the Cost of Goods Sold and Ending Inventory, using the LIFO method of Inventory Valuation.
- c) Calculate the Cost of Goods Sold and Ending Inventory, using the Average Cost method of Inventory Valuation.
Question #2: Answer
Units / Unit Cost / Total CostJanuary 1 / Opening Inventory / 100 / $20 / $2,000
April 25 / Purchase / 200 / $26 / $5,200
July 26 / Purchase / 300 / $28 / $8,400
October 3 / Purchase / 250 / $30 / $7,500
850 / $23,100
a) FIFO Cost of Goods Sold (670 Awesomes)
Units / Unit Cost / Total Cost100 / $20 / $2,000
200 / $26 / $5,200
300 / $28 / $8,400
70 / $30 / $2,100
670 / $17,700
Therefore, the Cost of Goods Sold using FIFO would be $17,700
Ending Inventory = 180 x $30 = $5,400
b) LIFO Cost of Goods Sold (670 Awesomes)
Units / Unit Cost / Total Cost250 / $30 / $7,500
300 / $28 / $8,400
120 / $26 / $3,120
670 / $19,020
Therefore, the Cost of Goods Sold using LIFO would be $19,020
Ending Inventory = (80 x $26) + (100 x $20) = $4,080
c) Average Cost Method
Average Cost per Unit = Total Cost / Number of Units = $23,100 / $850 = $27.18 per Unit
Cost of Goods Sold = $27.18 x 670 = $18,210.60
Ending Inventory = $27.18 x 180 = $4,892.40
Effects on the financial statements
To illustrate how the choice between FIFO, LIFO and Average Cost affect the financial statements, we will continue to use the Athabasca Company from earlier. The following chart reviews the calculationsthat weremade:
Method / Cost of Goods Sold / Ending InventoryFIFO / $695 / $150
LIFO / $725 / $120
Average Cost / $711.20 / $133.80
To summarize the effects on the income statement, in a period of rising prices:
FIFO / LIFO / AVERAGECost of Goods Sold / Lowest / Highest / In Between
Gross Profit/Net Income / Highest / Lowest / In Between
Ending Inventory / Highest / Lowest / In Between
Balance Sheet Implications
The account that isaffected on the balance sheet is the Merchandise Inventory account. This account will have the same value as the Ending Inventory on the Income Statement. The assets for a company will be highest using FIFO and lowest using LIFO, in a period of rising prices. This could have implications for investors in a company, as you will see in Unit 7. Using LIFO or Average Cost could also be an inaccurate representation of the current replacement costs of the goods in inventory.