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Inventory Basics

Apr 01, 2009

If your business has inventory, it will be required to keep its accounting records on the accrual method. You can select from several ways to compute your inventory, but once you make a selection, you cannot change the method without a good reason.

Periodic vs Perpetual Inventory Method
There are two different choices to make in deciding how to account for your inventory. The first is to decide if you will use the periodic inventory method or the perpetual inventory method.

Under the periodic inventory method the units of inventory sold are not subtracted from the inventory list of units available until the end of the fiscal period. With the perpetual inventory method, every time there is a sale, the units sold are subtracted from the units on hand and a new value of the inventory is computed.

Removing Sold Items from Inventory
The second choice is the method of removing sold items from your list of inventory. The choices are:

  • First in, first out (FIFO)
  • Last in, first out (LIFO)
  • Weighted average
  • Specific identification

First In, First Out (FIFO)
The FIFO inventory method assumes that costs are charged against revenue in the order in which they are incurred. This means that the most recent costs are still in inventory. For example, if you sell bicycles and one was purchased on Jan 3 for $85, one on Mar 5 for $78 and one on Sept 15 for $90, the total inventory purchases for this item would be $253. If one of these bikes sold on Oct 3, under FIFO the bike purchased on Jan 3 would be the one taken out of inventory and added to cost of goods sold. Your ending inventory under this method would be $168.

Last In, First Out (LIFO)
The LIFO inventory method assumes that costs are charged against revenue in the reverse order of which they were incurred. This means that the oldest costs are in the ending inventory. In the example above, when the bike is sold, the LIFO method would dictate that the bike sold was the one most recently purchased. This means that $90 is the amount removed from inventory and added to cost of goods sold. The ending inventory under this method would be $163.

Weighted Average
The weighted average method is also sometimes called the average cost method. This method assumes that the same value per unit is allocated to items remaining in inventory as to items that were sold. The calculations for the method are usually much simpler than those for LIFO or FIFO. In the example above, the average cost per unit would be $253/3 or $84.33 each. This means that $84.33 would be removed from inventory and charged to cost of goods sold. The balance in the inventory account at the end of the fiscal period under this method would be $168.66.

Specific Identification
The final method is specific identification. This method can only be used if the units in the inventory can be specifically traced. Under the example above, when the sale was made, the blue bike which was purchased on March 5 was sold, leaving the red bike purchased on Jan 3 and the black bike purchased on Sept 15. That specific item would be removed from inventory under this method. Cost of goods sold would be increased by $78 and inventory would be decreased by that amount. The final inventory balance at the end of the period would be $175.

As you can see, the method of tracking inventory that you chose will result in different results. The method chosen should be the one that makes sense for the business and is manageable for your accounting system.
 

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Courtesy of NASE.org
https://www.nase.org/business-help/get-help/finance-accounting/finance-accounting-blog/finance-accounting/2009/04/01/Inventory_Basics