In our last article, we reviewed Inventory, how it is defined and how it is measured. In this article, we explain how to account for differences in Inventory costs for groups of items and how to report those at the end of a reporting period. For example, let’s assume that over the course of the reporting period, we have purchased raw materials at varying prices. At the end of the reporting period, we need to determine how to report the cost of the remaining raw material inventory (Ending Inventory cost) and how to value the raw materials used in production and eventually sold. The question we will ask ourselves is: what cost should we use, given that we purchased the material at various different prices?
Two Types of Inventory Systems Exist:
First, let’s review the two main types of Inventory systems used by entities. This informs which approach we use to costing our Inventory. The two systems are:
Periodic Inventory System: Inventory is calculated on a periodic basis. This approach does not use a running count for inventory. Rather, the inventory is recorded in separate purchases accounts. The final quantities are later determined through inventory counts.
Perpetual Inventory System: This system requires a running balance of inventory that is increased with each purchase and decreased with each sale. Balances are then later confirmed (double-checked) through physical counts.
Two Approaches to Costing:
There are also two standard approaches for costing Inventory.
First In First Out (FIFO)
Weighted Average
We review reach approach in greater detail below. Note that there are other approaches available, such as Last In First Out (LIFO), but this is not an appropriate costing approach for reporting purposes, so we are not going to review it.
Standard Costing: FIFO
First In First Out (FIFO) means the first inventory in will also be the first inventory to be sold. Depending on our Inventory system, we can use either FIFO Periodic or FIFO Perpetual.
To calculate ending Inventory cost using the FIFO Perpetual method can take a lot of work, and may require us to create a running tabular balance to keep track of how much we paid for each item.
The goods news is…...
FIFO Periodic and FIFO Perpetual will ALWAYS result in the same inventory balance! Which is very exciting, because it means that we can take a shortcut in determining our Inventory cost at the end of a period.
Here’s how we calculate our ending Inventory costs, using an example.
FIFO Calculation Example:
Let’s assume that at the end of a period, we have 1000 units of raw materials left. Of those 1000 units, 600 were purchased at one price, and 400 were purchased earlier at a different price, as shown below.
1000 units in ending Inventory
600 units are from the last purchase @ $15/unit
400 units are from the second last purchase @ $14/unit
We would calculate our ending Inventory cost as follows:
Total Ending Inventory Cost = (600 x $15/unit) + (400 x $14/unit) = $14,600.
Because the first units that were converted into Work in Progress, Finished Inventory or Goods Sold, were already accounted for based on the First In First Out principle, the last units remaining will have a cost based on the last purchases made. Therefore, we only need to look at the most recent purchases to determine how much our ending Inventory costs.
Standard Costing: Weighted Average
The weighted average method weighs the average cost of Inventory, over the period. Depending on our Inventory system, we can use either Weighted Average Periodic or Weighted Average Perpetual.
Weighted Average Periodic
Weighted Average Periodic simply takes the total costs incurred for all Raw Inventory, and weighs that on a per unit basis, at any given point in time. To determine the cost of ending Inventory, we use a fairly simple formula.
Cost of Ending Inventory =
(Total Purchase Costs / Total Number of Units Purchased) x Number of Units in Ending Inventory
Weighted Average Perpetual
On the other hand, weighted average perpetual constantly updates the weighted average cost. To determine the cost of ending Inventory using the Weighted Average Perpetual method will likely require us to create a table so that we can keep track of the continuously changing cost.
Below is an example/template table, providing us with a cost for our ending Inventory.
Our ending cost of Inventory is $14,180. In both this example and the FIFO example we had 1,000 units in our ending Inventory, with 600 units purchased @ $15/unit and 400 units purchased @ $14/unit. However, we can see that our ending Inventory cost results in a different amount.
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