Perpetual Inventory - FIFO, LIFO, and Average Cost - Online Tutor, Practice Problems & Exam Prep

In a perpetual inventory system, cost flow assumptions like FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and average cost are essential for tracking inventory and cost of goods sold (COGS). FIFO sells the oldest inventory first, impacting COGS with older prices, while LIFO sells the newest inventory first, reflecting newer prices in COGS. The average cost method calculates COGS based on the average price of all units. The average is updated continuously, using the formula: $\frac{\left(\mathrm{Total\; Cost}\right)}{\left(\mathrm{Quantity}\right)}$.

Perpetual Inventory:FIFO, LIFO, and Average Cost

Alright, now let's discuss how to use FIFO, LIFO, and average cost in a perpetual inventory system. So we're going to use these FIFO, LIFO, and average cost methods. This is when we're selling large amounts of identical inventory, okay? So if you think about it, if we're selling a bunch of cans of soda, we're reselling identical cans of soda; you can't tell one can of soda from another, they're all going to be identical in essence, right? So we can't really tell the difference, so what we do is we use these cost flow assumptions, and that's going to help us track our cost of goods sold and inventory here, okay? So let's talk about what these are. The first one, 1st in, 1st out. This is our FIFO method, right? 1st in, 1st out, FIFO. So this means that the first unit that came into our inventory is going to be the first unit that we sell, okay? So the first unit that goes out of inventory. So the oldest unit is the one that gets sold first, okay? So for selling the oldest units first, that means that our cost of goods sold, well, the cost of goods sold is going to have what we paid for our older units, right? We're going to put our older units into cost of goods sold. Compare that to last in first out, this is the opposite here. LIFO, last in first out, well, that means that the newest unit that we received is the one that we're going to sell, okay? So, this is the newest unit gets sold first, okay? So, the cost of goods sold on the income statement, right? Our cost of goods sold is going to include what we paid for newer units, okay? So one quick thing before average cost, the whole trick to these questions when we deal with this FIFO, LIFO, the whole point of it is that we're buying units at different prices, okay? Every time we purchase, we're getting a different price and that forces us to use one of these methods to cost our inventory, okay? So the last one, average cost, This is that goods are sold at their average cost, right? The average cost and this is the average of what you paid for the units. That's what's going to go to COGS, Okay? So in a perpetual system, we have kind of a special thing with the average. It's called the moving average, right? Because we're perpetually updating the inventory record, so since we're always updating the record, well, we're going to constantly have to change the average. We're going to have to move the average based on the record. So, the average is going to be updated after each purchase and sale, Okay? So we are going to be updating that average quite, quite often, alright? And this is how we find our average is a pretty simple formula. This is going to give us a cost per unit, okay? A cost per unit which is just if we take the total cost of everything we have divided by the amount of units that we have, well that will give us the cost per unit, okay? Total cost divided by quantity in MathML format:

Total cost Quantity

And a very important note that I want to make here is that the cost flow assumption whether we're using FIFO, LIFO, average cost, it does not have to be consistent with the physical flow of goods, okay? Physical flow is which you know if we're selling cans of soda, which can can of soda we are actually selling? Well, that would be the physical flow, but that doesn't matter with the accounting records, we don't have to match that actual can with the cost of that actual can itself, right? We're going to use these methods to help simplify the process, and it doesn't have to align with which actual can we sold and what we paid for that can. No, that doesn't matter, okay? FIFO, LIFO, and average cost, we just look at it kind of in the big picture, alright? So let's go ahead and pause here and then we will start an example of how to use these methods in a perpetual system. Cool.

Perpetual Inventory FIFO

Alright. Let's go ahead and start this example with the FIFO method. So a company had the following inventory data for the month of July and then we've got some data. Notice here that this inventory data includes sales. It's not just purchases. In a perpetual system, right, we're always updating the system and that includes when we sell units as well. Okay? So we've got some sales, some purchases throughout the month and then it asks us. These questions are always going to ask us. This is always the end game to calculate cost of goods sold and ending inventory. Okay, notice if you were one of the people who had to study periodic inventory and perpetual inventory for these methods, notice that in the perpetual method, they don't give you a physical quantity for the ending inventory, right, because the perpetual method, it doesn't need the count, but a periodic method, you do need to count the ending inventory, okay? If you just have to do perpetual, well, don't worry about that little quip. Okay, so let's go ahead and start here with the FIFO method, okay? So we're going to think about what did we sell? What was the cost of goods sold in the FIFO method, okay? And this is going to be every time we have a sale, we're going to account for how much was the cost of goods sold for that sale. So first in first out, let's look at our sale on July 5th, okay? July 5th, we sold 700 units at $30 a piece, okay? Notice that since we're dealing with the cost side, we're talking about the cost of goods sold, we're talking about inventory, this $30 the selling at $30 that's the revenue that we brought in. That doesn't have to do anything with this discussion, our discussion now is on the cost side, not the money we bring in. What did it cost us for these sales? The cost of goods sold, okay? So that $30 is related to revenue not cost. So we sell these at $30 and how many units did we sell? 700 units, right? So we have to figure out which units we sold, 700 units and find out their price. Well, on July 5th, the only units we had on hand were the inventory balance from the beginning of the month, right? So the first in first out, well, the only units we have available are the inventory from July 1st, so that's what we're going to sell, 700 times $20 that's $14,000 right? That's the cost of goods sold from that sale. So at that point, since this is a perpetual system on July 5th, we would have made a journal entry to include in cost of goods sold $14,000 Okay? So the next thing we have to see is on July 23rd, the next sale where we sold 360 units, right? So those 360 units, we have to think about which purchases, which balances we're going to use for those 3 60 units, right? So since it's 3 60 units total, right? On that sale, we have to look at the first ones we have. So remember, from this July 1st balance, we already sold 700 of those, right? We already sold 700 on July 5th, so there's not a 1,000 left there, there's only 300 left, right? So this July 1st balance is going to be down to 300 units and that's what we're going to sell, the first units that we're gonna sell on this date, right? We already sold the first 700, we're talking about FIFO so we want to sell the oldest units, So we're going to sell the 300 units from July 1st at $20 right? 300 times 20 that's $6,000 Now what about the other 60 units, right? We sold now we've already sold everything from this balance, right? We sold 700 of those on July 5th and we sold 300 of those on July 23rd. Well the other 60, they're going to have to come from our oldest units and in this case the oldest units are going to be the purchase on July 11th, right? On July 11th we purchased 500 more units and in this case those are oldest units that are available for sale. Okay, so let's go ahead and sell those units right here. So we have 360 units, right? So there's going to be 60 that gets sold from the purchase on July 11th because we already accounted for 300 of those. Right? We're trying to get to a total of 360, so there's only 60 from that purchase that gets sold. 60 times $22.40, right? So that purchase on July 11th is now our oldest units. So 60 times 22.40, that gives us 1344. Okay? So I'm going to put the total here on the side because we need to find the total of this purchase, 1344 +6,000. So our total for this purchase is going to be here. Let me double underline these this and then 7344. Right? That's the total of these two numbers right here. So that's the total from July 23rd. Now, let's figure out the total from July 29th. So on July 29th, we sold 240 units, right? 240 units. So where are those units going to come from? They're going to come the ones we sold are going to come from ouroldest batch of inventory, so we had 500 units that were available for sale on July 11th, right? But we already sold 60 of those units. However, we still have enough to cover this whole sale, right? Because we're only selling 240. We had purchased I'll do it right here we had purchased 500 and then we sold 60 of them on July 23rd, well that leaves us with 440 units, right? But our sale was only 240. So that's enough to cover it. So all of those units, all 240 of those units are gonna come out of the July 11th purchase, right? Those are our first in first out. 240 units times a price of $22.40. Well, that's gonna equal let's see. 240 times 22.4, well, that's 5376. Okay? So that's going to be our total from that purchase right there or excuse me, from that sale, that's going to be the total cost of goods sold. So now, just to find the total cost of goods sold for the month, well that's just going to be the 14,000 from the first sale plus 7,344 from the second sale, plus 5376 from the 3rd sale. So what's that gonna give us? 26,720. So there you go. That is going to be that's going to be our cost of goods sold using the_FIFO_method there, alright? So let's go ahead and do our ending inventory now_in_FIFO. So remember, ending inventory is going to be the units that are left over. So what's left over? We sold all of the inventory balance from July 1st, how much of the inventory did we sell from July 11th? Well, we sold the 500 minus the 60 from July 23rd sale, but we also sold 240, right, On July 29th. So minus 240, that leaves us with 200 units are left in ending inventory from July 11th, right? So the July that we didn't sell times the that we didn't sell times the price of 22.40, you see where that 200 came from? There were 500 total units that we purchased that day and we sold 60 of those units on July 23rd and 240 of those units on July 29th, so we're left with 200 units from the July 11th purchase. So 200x2240, let's go ahead and find out what that is. That's 4,480, Okay? But that_not all the units left, right? There was more units left. How about the purchase on July 30th? We didn't sell any of those units. So we're going to be left with 600 units from July 30th that were $23.30. So let's see how much of those cost us right there. 600 times 23.3, 13,980. So there we go. We're ready to find our ending inventory. Plus 4,480 that comes out to 18,460. Cool? All right, so that is our answer right there. Our cost of goods sold total for the month was 26,720 and our total ending inventory was the 18,460. Cool? Let's go ahead and pause and we'll continue with the LIFO method.

Perpetual Inventory LIFO

Alright, let's continue with the same example using the LIFO method. Alright, so what we got to think about when we're doing cost of goods sold is each time we make a sale, we're going to make an entry for cost of goods sold, so we want to look at each sale. On July 5th, we made a sale at $30. Let me erase this stuff right here. Okay. So on July 5th, we made a sale at $30 remember that the sale price doesn't matter, we're only looking at cost here. So we sold 700 units, what were the last units that were available to sell at that date? Okay, so this is where it's a little tricky. You have to think of as of that date on July 5th, what were the last units available for sale? So on July 5th, the only units that were available for sale were the ones from July first, right? So even though those were the first ones from FIFO, they're still the last ones in LIFO because they're the only ones. Okay? So we're going to sell 700 units here times the $20 cost from July 1st, right? And that's gonna give us 14,000 in cost of goods sold on July 5th. Right? So notice that was the same as in the FIFO system, right? But now let's check out the next one. On July 23rd, we made a sale at $30 for 360 units, right? So now we are looking at July 23rd, There were 360 units and we made, but now when we think about the last units we purchased, right, think about LIFO as of July 23rd. Now we would pull the units from the July 11th purchase, right? They're not going to come out of beginning inventory. They're going to come out of the latest purchase as of that date and as of July 23rd, the latest purchase was the one on July 11th And notice on July 11th, there's enough units to cover all of this sale. So we can just do the 360 units times the July 11th price of 22.40. Right? So notice how that's a little different already because we had a purchase, we're looking at the last in first out now. So 360 times 22.4, that comes out to 8,064. Right? So notice yep. In this case, the last purchase was the LIFO for that number. Okay. So now let's do July 29th. So the July 29th purchase. So this is where things you have to keep track of how many units are left from each purchase. Right? So if you think about our inventory balance on July 1st, right, I would kinda keep a running total here where I'd be like, okay. There's 300 of these left. Here, I sold 360. So 500-360. Let's see how many of those are left. 500-360. There's a 140 of these left right here. Okay? So that kinda keeps track of how many we have left to sell. So now when we look at the July 29th sale, well the sale at July 29th, we sold 240 units. Which units were available? What was the last units available? That's going to be these 140 units we're going to want to sell, right? Those are the last ones available and then we're going to have to go to the previous which comes out of the July 1st balance. So the first ones we sell is those 140 units times the price of 22.40. Right? And let's see what that comes out to. I keep putting my phone away. Alright. 140 times 22.4 gives us 3136, but we didn't just sell a 140 units, right? We sold 240 units, so the other 100 have to come out of our beginning inventory balance, right? That's the last in before that. So 100 units come out of there and that price was $20. So that comes out to 2,000. Right? And we're gonna have a total from that day of 5,136. So that would be the total from that purchase or, excuse me, from that sale to total cost of goods sold. So now let's find the total for the entire month and that's just summing up these three numbers. So the 14,000 plus the 8,064 plus the 5,136. That's gonna give us our total cost of goods sold for the period. And let's see. 14,000 + 8,064 + 5,136 = 27,200. So there you go. That is our cost of goods sold using the LIFO method. Notice that's a little tricky here in the perpetual system, right? You have to keep track of which units are left, okay? So, that being said, now when we get to ending inventory, we really got to know what units are left, right? So if we think about this inventory balance from July 1st, we said there were 300 before that July 29th, but then we sold another 100, right? So we know there's only 200 left from July 1st inventory balance, right? Because we sold 700 on July 5th and we sold a 100 of them on July 29th, so there's 200 left and then what else is left is this purchase on July 30th. So let's go ahead and put that into our ending inventory. First, we have the 200 units from the beginning balance that are still left, 200 times \$20 and that comes out to 4,000, But then we also have the 600 units from July 30th. 600 times 23.3 gives us 13,980. So our total ending inventory is going to be 17,980. Right? That is our total ending inventory. We've got our cost of goods sold, so we're there with the LIFO method. Alright? One thing I want to note that's kind of tricky here with LIFO is look, we made a purchase on July method and the LIFO is that even though we had that purchase on July 30th, I don't want you to think of that as the last in first out. You want to go date by date, right? You want to think, okay, as of July 5th, what was the last in first out as of that date, right? Just like we did in the problem. Cool? Let's go ahead and move on to the weighted average or, excuse me, average cost method.

Perpetual Inventory Average Cost

Alright, so when we do the average cost method in the perpetual inventory system, we're going to have to keep updating that average. It's going to need continual updates because we're perpetually updating inventory, and that average is going to keep changing. So that's why I have these two purple boxes above. We're going to use them as a tool to help us solve these average costs. Alright? So the first thing we want to do is keep solving for what that cost per unit is. We want to use that average cost formula from above, right? Total cost divided by quantity to keep up our average and find what our average is.

So let's start on July 1st and see what our average cost per unit was on that day. Well, that's pretty simple, right? We only had one price, one set of units. So if we took our total cost, which would be 1,000 times the $20 per unit, 1000 \times 20 where the total cost is going to be $20,000, right? And how many units did we have on hand on that day? Well, we had 1,000, right? So our average cost per unit, which I'll do over here. I'm going to try and put them right here on the end. We'll calculate our average cost per unit which is just dividing, right? We're going to take our total cost divided by our unit balance. So 20000 \div 1000, well, that gets us back to $20 per unit, right? 20000 \div 1000 not a big revelation there, but now let's keep going here.

Let's think about the sale on July 5th. So the sale on July 5th, well, we had an average cost of $20 per unit at that point, right? Nothing crazy has happened yet, so we would have sold units of 700 units at a price of $20 per unit. Okay? And notice, this is the same for all the cases, right? Because there were no purchases made before the first sale, so that's what was available. We sold 700 units at $20 per unit. So what's going to happen after that sale, our unit balance is going to decrease down to 300, right? Now we only have 300 units on hand, but those units all have a cost of $20 still, right? All those units have a cost of $20 so it would just be 300 \times 20 and that's just $6,000 right, and that makes sense because there was $20,000 total value and $14,000 went to the cost of goods sold, so the remaining $6,000 is still sitting there in inventory and we still got a $20 per unit average cost over there. Okay?

So now we're going to make a purchase. Notice, we're making a purchase here on July 11th, so we had 300 units previously left unsold plus now 500 units. So we have a total of 800 units and this is where you're going to see the moving average because we're going to keep updating, right? So now we have 800 total units in inventory. We had those 300 that had a value of $6,000, right? But now we added a value of 500 times 22.4, right? So the first 300 units had that value of $6,000, the next 500 have this value. So let's go ahead and find out the total cost in inventory, 500 \times 22.4. Oops. 500 \times 22.4. There it is. So, 500 \times 22.4 that's $11,200, that's what we paid for this new shipment on July 11th, but we have to add what was left over from the beginning balance which is that $6,000 value from the previous line, right? So we get a total value of $17,200 in this case. So now that we have a total cost, we have a total amount of units, 800, let's go ahead and divide to get our average cost. 17200 \div 800 = 21.50 per unit. So notice, this is the moving average. The average has now gone up to $21.50 per unit, Okay. So now we're ready. We have our average ready for our next sale. So the sale happening on July 23rd, we sell 360 units and we're just going to take the 360 units times that average price, 21.50. Right? So what's that going to come out to? 360 \times 21.5, that's $7,740, right? So notice how easy these final calculations are, right? We're just taking that average cost and multiplying. We Okay so we sold 360 units, right? So we had 800 units minus 360. That's gonna get us to how many units left? 800-360. There's 440 units left on hand and while we had $17,200, right, that was our previous total cost, but then we sold some of it, right? We sold this value, $7,740, right? So that's what we took out of our total cost in inventory. So let's see what's left. $17200 \div 7600 \div 440 = 21.50, we still have that 2150 average. Okay? So that makes our next sale on July 29th pretty easy, right? Because we have the same average, we're just going to go 240 \times 21.50. What's that gonna give us? $5,160. Right? So there we go. Now we've got an average cost for all of our sales.

Let's go ahead and finish this up here. So we have 440 units minus 240, So we were left with 200 units at that point and we had a cost of $9,460 previously, but now we're taking out $5,160 in that sale, right? That sale $5,160, that's what we're taking out right there. So what's left in inventory? $9,460 minus $5,160, $4,300. And guess what? $4,300 divided by the 200 units left, we're still going to have that average of $21.50 per unit here. Okay? And now, we've got our final purchase. Right? So now, we're going to purchase units on July 30th. So 200 plus the 600 units we purchased gets us to 800 total units. And how much did we spend on that purchase? So well, previously we had a value of $4,300, right, from the previous line plus this purchase of 600 times $23.30. Right? 600 \times 23.3, that's $13,980, but we have to add $4,300. It gets us to a total of $18,280. Right? So the 600 \times 23.3 and then we add $4,300 to get the total value and now we divide that by the 800 units and this gives us an ending average cost of $22.85 per unit. Okay? So our ending cost is $22.85 per unit, but at the same time we just found our ending inventory, didn't we? Because we took everything that was left, the $4,300 plus this new purchase that we haven't sold yet and we found the value of it, right? So that total cost of $18,280, that's going to be the value of our ending inventory. Okay?

So our ending inventory, it's just going to be what's left on hand or you could do the same thing where we calculated this average cost of $22.85 and multiply it by how many units there are on hand. Right? So let's just do that. We had 800 units on hand times $22.85 average cost. So what do we get? And it should be the same number, that we have up there because that's how math works. So there it is, $18,280, right? Oh, we didn't do the total for the cost of goods sold. So all we have to do is add the $14,000, the $7,740, and the $5,160 from each sale. $14,000 plus $7,740 plus $5,160 gets us to our total cost of goods sold of $26,900. So let me write all that in. $14,000 plus $7,740 plus $5,160 equals $26,900, and that would be our answer right here. Okay? So those are our two answers for COGS and ending inventory in the average cost system. Cool? So you saw here with the perpetual, that average moves after each purchase, right? We're going to see that the average changes after each purchase in this case. Alright? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the difference between FIFO and LIFO in a perpetual inventory system?

In a perpetual inventory system, FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are methods used to track inventory and cost of goods sold (COGS). FIFO assumes that the oldest inventory items are sold first, so COGS reflects the cost of older inventory. Conversely, LIFO assumes that the newest inventory items are sold first, so COGS reflects the cost of newer inventory. This difference impacts financial statements, especially in periods of price fluctuation. FIFO typically results in lower COGS and higher net income when prices are rising, while LIFO results in higher COGS and lower net income.

How is the average cost method calculated in a perpetual inventory system?

In a perpetual inventory system, the average cost method calculates the cost of goods sold (COGS) and ending inventory based on the average cost of all units available. This average is continuously updated after each purchase and sale. The formula used is:

$\frac{\mathrm{Total} \mathrm{Cost}}{\mathrm{Quantity}}$

This gives the cost per unit. Each time new inventory is purchased, the total cost and quantity are updated, and a new average cost per unit is calculated.

Why do companies use cost flow assumptions like FIFO, LIFO, and average cost?

Companies use cost flow assumptions like FIFO, LIFO, and average cost to simplify the process of tracking inventory and calculating the cost of goods sold (COGS). These methods help manage inventory costs when identical items are purchased at different prices over time. FIFO, LIFO, and average cost provide systematic approaches to determine which costs are assigned to COGS and ending inventory, ensuring consistency and accuracy in financial reporting. These assumptions do not need to match the physical flow of goods, allowing for flexibility in accounting practices.

How does the perpetual inventory system differ from the periodic inventory system when using FIFO, LIFO, and average cost?

In a perpetual inventory system, inventory records are continuously updated with each purchase and sale, providing real-time data on inventory levels and cost of goods sold (COGS). When using FIFO, LIFO, and average cost, the perpetual system requires constant recalculations. In contrast, a periodic inventory system updates inventory records at specific intervals, such as monthly or annually. This means that COGS and ending inventory are calculated only at the end of the period. The perpetual system offers more accurate and timely information, while the periodic system is simpler but less precise.

What are the advantages and disadvantages of using the FIFO method in a perpetual inventory system?

The FIFO (First-In, First-Out) method in a perpetual inventory system has several advantages and disadvantages. Advantages include a more accurate reflection of inventory costs, as older, potentially lower-cost items are sold first, which can result in higher net income during periods of rising prices. It also aligns well with the actual physical flow of many products. However, disadvantages include potentially higher tax liabilities due to higher reported income and less relevance in industries where the newest items are sold first. Additionally, during periods of inflation, FIFO can overstate profits and inventory values.