Costing Methods in Accounting

FIRST-IN FIRST-OUT (FIFO)

In most companies, FIFO costing remains constant according to the physical movement of inventory.  Under FIFO method, costs of merchandise are always integrated in cost of sold by following the same order in which they were purchased that often reflects the physical flow of the merchandise. Therefore, the FIFO method often provides results similar to those which might have been acquired by using the particular recognition method.

The FIFO (first-in, first-out) method states that the earliest goods purchased are the first to be sold. FIFO method generates the excellent business performance by selling the oldest units first. Under the FIFO method the costs of the earliest goods purchasing determining the first cost of goods sold.

But it is always not necessary that oldest units are sold first but that the costs of the oldest units are determined. Under FIFO ending inventory is determined based on the prices of the most current units purchased because under FIFO method it is thought that the first goods purchased were the first goods sold. If any company uses FIFO method, then in order to acquire the cost of the ending inventory that company receives the unit cost of the most recent purchase and works back until all units of inventory have been recorded.

For example, Hz Company uses FIFO method and in the normal course of business the company prices the 600 units of ending inventory using the most current prices. The last purchase was 560 units at $40 on august 30.The rest 40 units of inventory are priced with the unit cost of the second most current purchase $35 on may 28. And then Houston Electronics find the cost of goods sold by subtracting the cost of the units of ending inventory from the cost of all goods available for sale.

How HZ Company applies their FIFO method in their operation are given below with example:

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost
Jan.  1 Beginning   inventory 100 10 1,100
Mar. 10 Purchase 200 11 2,200
May 28 Purchase 140 35 4,900
August 30 Purchase 560 40 22,400
Total   1,000   30,600

STEP 1: ENDING INVENTORY                                   

Date Units Unit Cost Total Cost
August 30 560 40 22,400
May     28 40 35 1,400
Total 600   23,800

STEP 2: COST OF GOODS SOLD

Cost of goods available for sale 30,850 
Less: Ending inventory 23,800
Cost of goods sold  7,050

LAST-IN, FIRST-OUT (LIFO)

lifo accounting systemThe LIFO is the just reverse side of FIFO method. Once the LIFO method was only approached in such rare situation the units sold were taken from the currently purchased units. Now a day the LIFO method is now widely applied for tax purposes. But LIFO method does not represent the physical flow of units.

The LIFO (last-in, first-out) method states that the latest goods purchased are the first to be sold. Under the LIFO method, the costs of the latest goods purchased are the first to be identified for finding the cost of goods sold. Under LIFO ending inventory is determined based on the prices of the oldest units purchased because under LIFO method it is thought that the first goods sold were those that were most currently purchased. If any company uses LIFO method then in order to acquire the cost of the ending inventory that company receives the unit cost of the oldest units purchase and works back until all units of inventory have been recorded.

For example, ABC Company uses LIFO method. The company prices the 300 units of ending inventory with the earliest prices. The beginning inventory of 100 units was purchased in January 1 at $12.Then 100 units were purchased at $10 per unit in Mar 10. The rest 100 units are priced at $14 per unit in May 28.then the measure the cost of goods sold by subtracting the cost of the units of ending inventory from the cost of all goods available for sale.

How ABC Company applies their LIFO method in their operation activity are given below with example:

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost
Jan.  1 Beginning   inventory 100 10 1,100
Mar. 10 Purchase 200 11 2,200
May 28 Purchase 140 35 4,900
August 30 Purchase 560 40 22,400
Total   1,000   30,600

STEP 1: ENDING INVENTORY                                  

Date Units Unit Cost Total Cost
Jan.  1 100 12 1,200
Mar. 10 100 10 1,000
May 28 100 14 1,400
Total 300   3,600

STEP 2: COST OF GOODS SOLD

Cost of goods available for sale  30,600 
Less: Ending inventory    3,600
Cost of goods sold 27,000

Average Cost

The average-cost method is also a cash flow method. Under this method, a company basically computes a new average cost per unit after each purchase occurred. Ending inventory and cost of goods sold are calculated based on the average cost per unit. A company who uses the average-cost method allocates the cost of goods available for sale on the basis of the weighted average unit cost which is incurred. The average-cost method states that the merchandises have common characteristics.

In order to determine the cost of the ending inventory the company applies the weighted average unit cost to the units on hand. Under average cost method the weighted average unit cost is determined by dividing the total units available for from cost of goods available for sale.

For example, cost of goods available for sale is $15000 and total units available for sale is $1500 then the weighted average unit cost will be $10.

Cost of goods available for sale/ Total units available for sale = Weighted average unit cost
15,000/ 1,500 10

The cost of goods sold by using the average cost method could be verified by multiplying the units sold times the weighted average unit cost which is as follows:

(300 * $10 = $3,000).

Average cost method is basically used in periodic inventory system. This averaging technique is referred as a moving average. The average cost method is rarely used in a perpetual inventory system.