Chapter 6 Inventories 269
items, it must determine a unit cost so that it can record the proper accounting entry.
To illustrate, assume that three identical units of Item X are purchased during May, as
shown below.
Item X Units Cost
May 10 Purchase 1 $ 9
18 Purchase 1 13
24 Purchase 1 14
Total 3 $36
Average cost per unit $12Assume that the company sells one unit on May 30 for $20. If this unit can be iden-
tified with a specific purchase, the specific identification methodcan be used to determine
the cost of the unit sold. For example, if the unit sold was purchased on May 18, the
cost assigned to the unit would be $13, and the gross profit would be $7 ($20 $13).
If, however, the unit sold was purchased on May 10, the cost assigned to the unit
would be $9, and the gross profit would be $11 ($20 $9). The specific identification
method is normally used by companies that sell relatively expensive items, such as
jewelry or automobiles. For example, Oakwood Homes Corp., a manufacturer and
seller of mobile homes, stated in the footnotes to its annual report:
Inventories are valued at the lower of cost or market, with cost determined using the
specific identification method for new and used manufactured homes....The specific identification method is not practical unless each unit can be identi-
fied accurately. An automobile dealer, for example, may be able to use this method,
since each automobile has a unique serial number. For many businesses, however,
identical units cannot be separately identified, and a cost flow must be assumed. That
is, which units have been sold and which units are still in inventory must be assumed.
Three common cost flow assumptions are used in business. Each of these as-
sumptions is identified with an inventory costing method, as shown below.
When the first-in, first-out (fifo) methodis used, the ending inventory is made up
of the most recent costs. When the last-in, first-out (lifo) methodis used, the ending
inventory is made up of the earliest costs. When the average cost methodis used, the
cost of the units in inventory is an average of the purchase costs.
To illustrate, we use the preceding example to prepare the income statement for
May and the balance sheet as of May 31 for each of the cost flow methods. These fi-
nancial statements are shown in Exhibit 3.