ACC203 - INTRODUCTION TO COST ACCOUNTING I
What is Inventory?
Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.
The following equation expresses how a company's inventory is determined:
Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory
In other words, you take what the company has in the beginning, add what it has purchased, subtract what's been sold, and the result is what remains.
How Do We Value Inventory?
The accounting method that a company decides to use to determine its inventory costs can directly impact the balance sheet, income statement and statement of cash flow. Three inventory-costing methods are widely used by both public and private companies:
First-In, First-Out (FIFO)
This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).
Last-In, First-Out (LIFO)
This method assumes that the last unit making its way into inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
Average Cost
This method is quite straightforward; it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
An important point in the examples above is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets.
Why is Inventory Important?
If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact same results. When prices are stable, our bakery would be able to produce all of its bread loaves at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.
Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.
If prices are rising, each of the accounting methods produce the following results:
FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay.
LIFO isn't a good indicator of ending inventory value because the leftover inventory might be extremely old and, perhaps, obsolete. This results in a valuation much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.
Average cost produces results that fall somewhere between FIFO and LIFO.
(Note: if prices are decreasing, then the complete opposite of the above is true.)
Keep in mind that companies are prevented from getting the best of both worlds. If a company uses LIFO valuation when it files taxes, which results in lower taxes when prices are increasing, it then must also use LIFO when it reports financial results to shareholders. This lowers net income and, ultimately, earnings per share.
What is 'Weighted Average'
Weighted average is a mean calculated by giving values in a data set more influence according to some attribute of the data. It is an average in which each quantity to be averaged is assigned a weight, and these weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that many like items with the same value involved in the average.
BREAKING DOWN 'Weighted Average'
A weighted average is most often computed with respect to the frequency of the values in a data set. A weighted average can be calculated in different ways, however, if certain values in a data set are given more importance for reasons other than frequency of occurrence.
Calculation of Weighted Average
Investors often compile a position in a stock over several years. Stock prices change daily, so it can be tough to keep track of the cost basis on those shares accumulated over a period of years. If an investor wants to calculate a weighted average of the share price he paid for the shares, he has to multiply the number of shares acquired at each price by that price, add those values and then divide the total value by the total number of shares.
Under this method, simple average rate at cost is obtained by adding the rate of purchases represented by stock at the time of issue & then dividing the same by the number of such rates. The rate needs to be revised at the time of any new purchase or exhaustion of any existing stock. For the purpose of ascertaining the average rate, the quantity by which each purchase is made has to be ignored.
To dampen the severity of the effect of rises & falls in the purchase price, use of any kind of average rate is made. Thus, in case of fluctuating rates of purchase, average cost is used. However, obviously, cost does not get properly represented by the average cost.
