Chapter 2 Understand the Costing Method
CHAPTER 02.01 COSTING METHOD
There are several possible inventory costing methods, which are:
a) first in first out method (FIFO)
– first goods purchased are also the first goods sold.
b) last in first out method (LIFO)
– last item of inventory purchased is the first one sold.
c) weighted average method.
– valuing both inventory and the cost of goods sold based on the average cost of all materials bought during the period.
CHAPTER 02.02 FIFO COSTING METHOD
first in, first out (FIFO)
– first goods purchased are also the first goods sold.
In most companies, FIFO Method assumption
a) closely matches the actual flow of goods,
b) considered the most theoretically correct inventory valuation method
c) reduces the risk of obsolescence.
d) valued close to current replacement cost.
e) During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold compare the three approaches, and the highest net income.
Example of the First-in, First-out Method
Example of the First-in, First-out Method in Autocount stock card
CHAPTER 02.03 LIFO COSTING METHOD
last in, first out (LIFO)
– last item of inventory purchased is the first one sold.
During periods of inflation, LIFO will result
a) highest estimate of cost of goods sold among the three approaches, b) the lowest net income.
Example of the Last-in, First-out Method
Example of the Last-in, Last-out Method in Autocount stock card
CHAPTER 02.04 WEIGHTED AVERAGE COSTING METHOD
The weighted average method
– valuing both inventory and the cost of goods sold based on the average cost of all materials bought during the period.
– used to assign the average cost of production to a product.
Example of the Weighted Average Method
Example of the Weighted Average Costing Method in Autocount stock card
CHAPTER 02.05 DIFFERENCE BETWEEN FIFO & LIFO METHOD
a) What are FIFO & LIFO what are they used for
Why use one method over the other? Here are some considerations that take into account the fields of accounting, materials flow, and financial analysis:
| Issue | FIFO Method | LIFO Method |
| Material flow | In most businesses, the actual flow of materials follows FIFO, which makes this a logical choice. | There are few businesses where the oldest items are kept in stock newer items are sold first. |
| Inflation | If costs are increasing, the first items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes | If costs are increasing, the last items sold are the most expensive, so your cost of goods sold increases, you report less profits, and therefore pay a smaller amount of income taxes |
| Deflation | If costs are decreasing, the first items sold are the most expensive, so your cost of goods sold increases, less profits, and less income taxes | If costs are decreasing, the last items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay more income taxes |
| Financial Reporting | There are no GAAP or IFRS restrictions on the use of FIFO in reporting financial results. | IFRS does not all the use of the LIFO method at all. The IRS allows the use of LIFO, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity. |
| Record Keeping | There are usually fewer inventory layers to track in a FIFO system, since the oldest layers are continually used up. This reduces record keeping. | There are usually more inventory layers to track in a LIFO system, since the oldest layers can potentially remain in the system for years. This increases record keeping. |
| Reporting Fluctuation | Since there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers. | There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold. |
In general, LIFO accounting is not recommended, for the following reasons:
- It is not allowed under IFRS, and a large part of the world uses the IFRS framework.
- The number of layers to track can be substantially larger than would be the case under FIFO.
- If old layers are accessed, costs may be charged to expense that vary substantially
a) Amendments to the Malaysian Private Entities Reporting Standard (effective 1 January 2017 with early application permitted).
CHAPTER 02.06 ADVANTAGE & DISADVANTAGE BETWEEN FIFO & WEIGHTED AVERAGE METHOD
| Issue | FIFO Method | Weighted Average Method |
| Advantage | first inventory bought is the first inventory sell. Tell the actual cost useful for products that have shelf life such as groceries sell the items ordered first, know exactly how much they cost and how much profit making. If you are in manufacturing, you know the exact cost of the materials for each product as it is manufactured |
set prices based on average inventory cost by simply marking up the average a lower profit margin for inventory that was the most expensive have a lower profit margin, make up for that with a higher profit margin on the lower-cost inventory. This works well for companies that mix their inventory as it comes in. |
| Disadvantage | lose or damage any inventory, need to know exactly where the loss in inventory is in order to know its value FIFO gives different production costs for each product manufactured. If the materials for two units have different price,each of those units has a different cost. If mark up costs to get selling price, units would have different selling prices. |
particular product could have higher costs than the others, return any inventory unsold, average cost becomes inaccurate. selling the remaining inventory at too low a price to make a reasonable profit decide to get rid of inventory by discounting it based on the average cost, could be selling some of it at a loss because it was actually more expensive than the rest of the inventory.report. |
CHAPTER 02.07 THE IMPACT OF DIFFERENCE COSTING METHOD
Examine each of the following comparative illustrations noting how the cost of beginning inventory and purchases flow to ending inventory and cost of goods sold.
Detailed Example
FIFO
If uses FIFO, ending inventory, cost of goods sold, and the resulting financial statements are as follows:
LIFO
If Gonzales uses LIFO, ending inventory, cost of goods sold, and the resulting financial statements are as follows:
Weighted Average
If Gonzales uses the weighted-average method, ending inventory and cost of goods sold calculations are as follows:
These calculations support the following financial statement components.
Comparing Methods
The following table reveals that the amount of gross profit and ending inventory can appear quite different, depending on the inventory method selected:
The preceding results
– LIFO produces the lowest income (assuming rising prices, as was evident in the Gonzales example),
– FIFO the highest,
– weighted average an amount in between.
– LIFO tends to depress profits, one may wonder why a company would select this option; the answer is sometimes driven by income tax considerations.
– Lower income produces a lower tax bill, thus companies will tend to prefer the LIFO choice.
– Usually, financial accounting methods do not have to conform to methods chosen for tax purposes.
– FIFO is better because recent costs are reported in inventory on the balance sheet.
Whichever method is used, it is important to note that the inventory method must be clearly communicated in the financial statements and related notes.
Consistency in method of application should be maintained.
This does not mean that changes cannot occur;
however, changes should only be made if financial reporting is deemed to be improved.
