Accounting and Finance Foundations

Unit 7

Accounting and Finance Foundations Unit 7: Financial Statements 548

Financial Statements

Chapter 18

Student Guide

Valuing Inventory

Under US GAAP, three different methods of inventory valuation are commonly used to calculate cost of

goods sold under the Periodic Method. These methods include FIFO (first-in, first-out), LIFO (last-in, first-

out) and average cost.

If your company uses the FIFO method, it sells the oldest units of inventory. For example, let us assume

that your company bought 40 items in inventory early in an accounting period. The 25 products that you

bought first cost $1.00 each to purchase, while the 15 newer items cost $2.00 each. Suppose that custom-

ers purchased 20 of those products during the period. Based on FIFO, you sold 20 of the oldest items in

inventory. So, at the end of the accounting period, you would have five of the older $1.00 products left,

along with all 15 of the newer $2.00 items. Therefore, your ending inventory balance would be $35.00.

If you company uses the LIFO method to value inventory costs, the opposite is assumed—the newest

inventory is sold before any older products are sold. So, if we purchased the same 40 units in inventory

early in the accounting period as in the example above, and customers still purchased 20 products, we can

assume, under LIFO, that the products that cost $2.00 each were sold first—before selling the items that

costs $1.00. As a result, at the end of the accounting period, you would have $20 in inventory (20 older

units) remaining.

Let’s get back to the cost of goods sold, though. Think for a moment about how much money your com-

pany spent on inventory during the accounting period. $55.00, right? ($1.00 X 25 = $25; $2.00 X 15 = $30;

$25 + $30 = $55). Your company’s cost of goods for the 20 products that it sold would be equal to the cost

of the goods available for sale ($55) minus the value of the ending inventory ($20). You could also calcu-

late the cost of goods sold by totaling the cost for each product sold during the period. In this case, using

LIFO, that would be $35.00 (15 X $2.00 = $30; 5 X $1.00 = $5; $30 + $5 = $35). Either way, your cost of

goods sold is the same.

Now for the third method for valuing inventory. The average method for accounting for inventory cal-

culates inventory costs using the average cost of the products in inventory at the end of the accounting

period. The average is determined by dividing the total cost of inventory available by the total number of

products available in inventory (make sure to include the beginning inventory in both figures). Therefore,

using the average method to value inventory costs, your company would take the average cost per prod-

uct and multiply the number of products sold to determine the cost of goods sold. For example, if your

company has 40 products available for sale during the accounting period (25 products that cost $1.00 each

and 15 products that cost $2.00 each), the total cost of goods available for sale equals $55.00 ($25.00 +

$30.00). The average cost per product equals $55.00 divided by 40 products, equals $1.38 per product. If

20 products are sold, value of ending inventory would be $27.60 (20 items remaining X $1.38). The cost of

goods sold would be $27.60 as well (20 items sold X $1.38).

Gross Profit

After calculating the revenues and cost of goods sold (presented on the income statement), you can calcu-

late the gross margin or gross profit. To do so, you should determine the difference between revenues and

cost of goods sold. (Make sure that you do this before deducting general and administrative expenses.) If

the gross profit exceeds the operating expenses and income taxes, your company is likely to be successful.

The Income Statement Lesson 18.1 (cont’d)