Inventory Techniques in Financial Accounting
Financial accounting provides an essential skill set that is applicable in virtually
any situation that involves the sale and purchase of goods and services. Whether you own your own business or simply would like to know how to manage your own personal finances, a modest understanding of Generally Accepted Accounting Principles (GAAP) will permit you the ability to accurately identify, record, and communicate your selling and spending activity, and will, by default, allow you to make wiser financial decisions.
I will explain one concept that is fundamental, yet very essential, to businesses that operate on a perpetual inventory system. When a merchandising company orders new products for their inventory, it purchases them at a market-clearing price that changes over time. As the company begins to accumulate a volume of inventory after purchasing the same product at different times for different prices, the company must decide how to place a value on the goods that the sell and the goods that they have in inventory at a particular moment in time. Now, as you may have learned from even the most menial everyday undertakings, there are often a variety of correct ways to complete a task. Some approaches yield benefits that others do not. Similarly, there are different ways for a business to value its inventory. For the purposes of financial accounting, I will outline three of the most common techniques that accountants use to determine the value of goods in a business's inventorynamely, FIFO, LIFO, and weighted average.
Suppose you own a business that buys skateboards from a distributor and sells them out of a shop in town. You buy ten skateboards for $100 each on the first day of your business's operation. On the second day, you buy ten more skateboards for $110 each, which gives you a total of 20 skateboards valued at $2,100 in total. Finally, on the third day, you sell twelve of the skateboards that you have in inventory, leaving eight skateboards in your inventory. According to GAAP, the amount reported on your business's Cost of Goods Sold and Merchandise Inventory accounts depends on the way that you decide to value the goods that were sold.
First, consider the inventory technique of First In First Out (FIFO). This method ensures that the first items that arrived in inventory will also be the first to leave the store. Thus, in our example, when the twelve skateboards are sold on the third day, the seller will value the inventory sold giving priority to the cost of the first ten skateboards that arrived in inventory. Ten of the skateboards sold on the third day will be valued at $100 apiece and the last two will be valued at $110. Therefore, when computing the Cost of Goods Sold, there will be ten skateboards valued at $1,000 total and two skateboards valued at $220 total, which will credit the Cost of Goods Sold account for a total of $1,220. The ending inventory will then be calculated using the schedule of Cost of Goods Sold. The total inventory before any sales is $2,100, and after the sale, the ending inventory is $880.
If, however, your business were operating according to the Last In First Out (LIFO) inventory technique, your Cost of Goods Sold and Ending Inventory accounts would not have the same amounts as they would if you were using FIFO. Instead of giving priority to the first items that arrived in inventory, the items that you most recently purchased will be the first ones to leave the store. Using the same example where twelve skateboards are purchased, you will cost the ten skateboards valued at $110 each and two of the skateboards valued at $100 each. Thus, the total Cost of Goods sold will be $1,300 and the Ending Inventory will be $800, which is notably different than the values computed using the FIFO technique.
Another technique that is commonly used to calculate the value of inventory is Weighted Average (WAVG). When employing this technique, you compute the average cost of a single good by dividing the total value of goods in inventory by the total quantity of goods in inventory on the date of the sale. So, in our skateboard shop example, you would find the total value of the skateboards you have in inventory, $2,100, and divide it by the total number of skateboards in inventory, 20, to find an average cost of $105 per skateboard. Thus, to compute the Cost of Goods Sold for the twelve skateboards sold on the third day, you would simply find the total price of the twelve skateboards valued at $105 each, which is $1,260, leaving an Ending Inventory of $840.
To summarize, FIFO yielded an Ending Inventory of $880, where WAVG computed $840, and LIFO computed only $800. Clearly these values are quite significantly different and will affect the balance sheet accordingly. The question becomes which of these techniques is the best to use for the skateboard shop.
The assumption that the prices of goods generally rises over time has influenced many companies to enlist in the method that provides the greatest benefit for their particular firm. For example, many merchandising companies have subscribed to using LIFO because it provides an implicit tax benefit-- the comparatively low Ending Inventory at the end of the period implies a lower amount of taxable assets. Thus, the company pays less in taxes.
The preceding example of inventory techniques illustrates the concept that an understanding of financial accounting principles can provide an individual with a framework to make better financial decisions. A holistic understanding of these concepts can only help you to manage your finances more effectively and make your business more competitive.
Inventory Techniques in Financial Accounting
By: Nick McIlroy
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