Perpetual Inventory - FIFO, LIFO, and Average Cost: Videos & Practice Problems

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

In a perpetual inventory system, businesses often utilize cost flow assumptions such as FIFO (First In, First Out), LIFO (Last In, First Out), and average cost to manage their inventory effectively, especially when dealing with large quantities of identical items, like cans of soda. These methods help track the cost of goods sold (COGS) and the remaining inventory.

FIFO operates on the principle that the oldest inventory items are sold first. This means that the cost of goods sold reflects the cost of the earliest purchased units. For example, if a company bought cans of soda at different prices over time, under FIFO, the COGS will include the costs associated with the oldest cans, which can lead to lower COGS and higher profits during times of rising prices.

Conversely, LIFO assumes that the most recently acquired inventory is sold first. Therefore, the COGS will consist of the costs of the newest units. This method can result in higher COGS and lower profits when prices are increasing, as it reflects the cost of the latest purchases.

The average cost method calculates the COGS based on the average cost of all units available for sale during the period. In a perpetual system, this average is continuously updated after each purchase and sale, known as the moving average. The formula for determining the average cost per unit is straightforward: it is the total cost of all inventory divided by the total number of units available. This can be expressed mathematically as:

$$ \text{Average Cost per Unit} = \frac{\text{Total Cost of Inventory}}{\text{Total Units Available}} $$

It is crucial to note that the chosen cost flow assumption does not need to align with the actual physical flow of goods. For instance, while a business may physically sell the oldest cans first, the accounting records can reflect any of the cost flow methods without needing to match specific items sold to their respective costs. This flexibility allows businesses to simplify their accounting processes while still providing accurate financial reporting.

Perpetual Inventory FIFO

The FIFO (First In, First Out) method is a key inventory valuation technique used to determine the cost of goods sold (COGS) and ending inventory. In a perpetual inventory system, inventory records are continuously updated with each sale and purchase, allowing for real-time tracking of inventory costs.

To illustrate the FIFO method, consider a company with inventory data for July, which includes both sales and purchases. The primary goal is to calculate the COGS and ending inventory based on the order in which inventory items were acquired.

For instance, on July 5th, the company sold 700 units at a selling price of $30 each. However, for COGS, we focus on the cost of the inventory sold. Since the only available inventory at that time was from July 1st, which had a cost of $20 per unit, the COGS for this sale would be calculated as:

COGS = 700 \times 20 = 14,000

Next, on July 23rd, the company sold 360 units. By this date, 700 units from the July 1st inventory had already been sold, leaving 300 units from that batch. Therefore, the COGS for the July 23rd sale includes:

COGS from July 1st inventory = 300 \times 20 = 6,000

For the remaining 60 units, the company would draw from the July 11th purchase, which had a cost of $22.40 per unit:

COGS from July 11th inventory = 60 \times 22.40 = 1,344

Thus, the total COGS for the July 23rd sale is:

Total COGS = 6,000 + 1,344 = 7,344

On July 29th, the company sold 240 units, all of which came from the remaining units of the July 11th purchase. After selling 60 units on July 23rd, 440 units remained from the July 11th purchase. Therefore, the COGS for this sale is:

COGS = 240 \times 22.40 = 5,376

To find the total COGS for the month, we sum the COGS from all sales:

Total COGS = 14,000 + 7,344 + 5,376 = 26,720

Next, we calculate the ending inventory. The remaining inventory consists of units that were not sold. From the July 11th purchase, after selling 300 and 240 units, 200 units remain:

Ending inventory from July 11th = 200 \times 22.40 = 4,480

Additionally, the company has 600 units from the July 30th purchase, which were not sold, at a cost of $23.30 each:

Ending inventory from July 30th = 600 \times 23.30 = 13,980

Finally, the total ending inventory is calculated as:

Total Ending Inventory = 4,480 + 13,980 = 18,460

In summary, using the FIFO method, the total cost of goods sold for the month is 26,720, and the total ending inventory is 18,460. This method emphasizes that the oldest inventory costs are used first when calculating COGS, which can significantly impact financial reporting and tax obligations.

Perpetual Inventory LIFO

The Last In, First Out (LIFO) method is a crucial inventory valuation technique that impacts the calculation of Cost of Goods Sold (COGS) and ending inventory. Under LIFO, the most recently purchased items are considered sold first. This approach requires careful tracking of inventory levels and costs associated with each purchase.

For instance, on July 5th, a sale of 700 units occurred at a price of $30 per unit. The cost of these units was determined by the most recent inventory available, which was from July 1st at $20 per unit. Thus, the COGS for this sale was calculated as:

COGS = 700 \times 20 = 14,000

On July 23rd, another sale of 360 units was made. At this point, the last purchase before this date was on July 11th, priced at $22.40 per unit. Therefore, the COGS for this transaction was:

COGS = 360 \times 22.40 = 8,064

Moving to July 29th, a sale of 240 units required a more detailed calculation. After previous sales, 140 units from the July 11th purchase were still available, and the remaining 100 units had to be taken from the beginning inventory from July 1st. The calculations for this sale were as follows:

COGS from July 11th = 140 \times 22.40 = 3,136

COGS from July 1st = 100 \times 20 = 2,000

Total COGS for July 29th = 3,136 + 2,000 = 5,136

Summing the COGS from all sales during the month gives a total COGS of:

Total COGS = 14,000 + 8,064 + 5,136 = 27,200

To determine the ending inventory, it is essential to account for the remaining units. After the sales, 200 units from the July 1st inventory remained, valued at $20 each, contributing:

Ending Inventory from July 1st = 200 \times 20 = 4,000

Additionally, there were 600 units purchased on July 30th at $23.30 each, contributing:

Ending Inventory from July 30th = 600 \times 23.30 = 13,980

Thus, the total ending inventory is:

Total Ending Inventory = 4,000 + 13,980 = 17,980

In summary, using the LIFO method, the total COGS for the period was 27,200, and the ending inventory amounted to 17,980. It is important to remember that LIFO requires a date-specific approach to determine which inventory is sold, ensuring accurate tracking of costs and remaining units.

Perpetual Inventory Average Cost

In a perpetual inventory system, the average cost method requires continuous updates to the average cost per unit as inventory changes. This method involves calculating the average cost by dividing the total cost of inventory by the total quantity of units available. The formula for average cost per unit is:

Average Cost = \frac{Total Cost}{Quantity}

For example, on July 1st, if a company has 1,000 units at a cost of $20 each, the total cost is:

Total Cost = 1,000 \times 20 = 20,000

The average cost per unit is:

Average Cost = \frac{20,000}{1,000} = 20

On July 5th, if 700 units are sold at the average cost of $20, the remaining inventory consists of 300 units, still valued at $20 each, totaling $6,000. When a purchase occurs on July 11th, adding 500 units at $22.40 each, the new total cost becomes:

Total Cost = 6,000 + (500 \times 22.40) = 6,000 + 11,200 = 17,200

With 800 units now in inventory, the updated average cost per unit is:

Average Cost = \frac{17,200}{800} = 21.50

As sales continue, such as the sale of 360 units on July 23rd, the cost of goods sold (COGS) is calculated by multiplying the units sold by the average cost:

COGS = 360 \times 21.50 = 7,740

After this sale, the remaining inventory is 440 units, and the average cost remains unchanged at $21.50. This process continues with subsequent sales and purchases, updating the average cost as needed.

For instance, after a sale on July 29th of 240 units, the average cost still holds at $21.50, and the remaining inventory is calculated accordingly. When a new purchase occurs on July 30th, the total cost is recalculated, and the average cost is updated again. The final average cost after all transactions is determined to be:

Average Cost = \frac{Total Cost}{Total Units} = \frac{18,280}{800} = 22.85

Finally, the total COGS for all sales can be summed up to provide a complete picture of inventory costs. In this case, the total COGS is:

Total COGS = 14,000 + 7,740 + 5,160 = 26,900

This method illustrates how the average cost fluctuates with each purchase and sale, providing a dynamic view of inventory valuation in a perpetual inventory system.

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.