How to Determine Cost of Goods Sold and Ending Inventory
Though there are many methods to determine the costs of inventory
, the most common methods used are Last-in-first-out method, first-in-first-out method, and the weighted average method. These three methods are used in order to determine Cost of goods sold and ending inventory. Cost of goods sold is an important aspect of the income statement and ending inventory is an important part of the balance sheet under the current assets. In the first-in-first-out method, the cost of goods sold is based upon the cost of materials bought in the beginning of the period, yet the cost of inventory is based on the cost of materials bought later in the period. So basically the earlier merchandise needs to be sold before the new merchandise is sold under this method. The weighted average method uses the average cost of all units bought during the period to determine both inventory and cost of goods sold. The last-in-first-out method uses the cost of materials bought towards the end of the period to determine cost of goods sold. Because it uses the cost of materials bought towards the end of the period, the costs are closer related to current costs.
During periods of inflation the first-in-first-out method will result in the lowest estimate of cost of goods sold and highest estimate of net income. The last-in-first-out method give the highest estimate of cost of goods sold and the lowest estimate of net income. Inflation is a major factor in determining which method to choose. When inflation does not exist, all three methods would produce the same results. During periods of high inflation, many companies may choose to use the last-in-first-out method because of its tax benefits. There are tax savings through using the last-in-first-out method, for the net income is decreased through this method. However, even though the companies will be experiencing a decrease in net income and save in their taxes, they should remember that this will also cause an increase in cash flows.
When prices begin to rise, the first-in-first-out method is a better indication of ending inventory and, as stated before, increases net income. The net income is increased because older inventory is used to calculate the cost of goods sold. Because the first-in-first-out method is a good indicator of ending inventory, it only makes sense that the last-in-first-out method is not a good indicator of ending inventory. This is because the leftover inventory may be extremely old. The last-in-first-out method is a better indicator when prices are decreasing.
Now that we understand what each method is and its benefits, we will move on to figure out how to calculate the cost of goods sold and ending inventory using each method.
First we will explore the first-in-first-out method. Say you have a beginning inventory (BI) of 20 units at $2.00 for a total of $40.00. Later in the period you purchase 10 more units at $2.20 for a total of $22.00. So your inventory now consists of 30 units at a total cost of $62.00. Now, say you sell 22 units. Because you are using the first-in-first-out method, you must first deal with the first units that were present in your beginning inventory. You had 20 units at $2.00 for a total of $40.00. So you deduct those 20 units from the 22 total units you have sold. You now must deal with the remaining 2 units. The remaining 2 units would be considered a part of the purchase you made of 10 units at $2.20. So you take the 2 units and multiply by 2.20 and receive a total cost of the remaining 2 units to be $4.40. After the purchase of the 22 units, you are left with 8 units in your inventory at $2.20, for a total ending inventory (EI) of $17.6. Using the formula Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory, you can find out your cost of goods sold using the first-in-first-out method. So you take your Beginning Inventory (20 units at $2.00 = $40.00) + Purchases (10 units at $2.20 = $22.00) - Ending Inventory (8 units at $2.20 = $17.60) = Cost of Goods Sold ($44.40).
Now using the last-in-first-out method you would start out the same way with the same beginning inventory (20 units at $2.00 = $40.00) and the same purchases (10 units at $2.20 = $22.00). However, when using this method when you sell 22 units you would first deduct the 10 units at $2.20 for a total of $22.00. Then you would have 12 units at $2.00 for a total of $24.00. That then leaves you with a remaining 8 units at $2.00 for a total of $16.00 in your ending inventory. So using the formula, Beginning Inventory (20 units at $2.00 = $40.00) + Purchases (10 units at $2.20 = $22.00) - Ending Inventory (8 units at $2.00 = $16.00) = Cost of Goods Sold ($46.00).
Finally using the weighted average method, you would take the total cost of your inventory ($40.00+$22.00=$62.00) and divide it by the total number of units (20+10=30), which gives you $2.07 for the cost of each unit. So using this new cost per unit of $2.07, you multiply that by the 22 units you have sold to get a total cost of $45.47. You then have 8 units left at $2.07 a unit, which leaves you $16.56 in your ending inventory. Using the formula, Beginning Inventory (20 units at $2.00 = $40.00) = Purchases (10 units at $2.20 = $22.00) - Ending Inventory (8 units at $2.07 = $16.56) = Cost of Goods Sold ($45.44).
Now that we have gone through the three methods to find the value of inventory, you should be able to define all three methods and know how to use each one to determine ending inventory and cost of goods sold.
How to Determine Cost of Goods Sold and Ending Inventory
By: jn736906@wcupa.edu
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