Inventory accounting and manipulating Cost of Goods Sold (CGS)
Walking through a store at the mall, one might wonder how it is that a company comes up with the prices they see on the shelves
. After all, most retailers are only middlemen who serve between producers and consumers. Any business, whether it is a neighborhood pharmacy or a billion dollar multinational corporation, uses a relatively simple accounting model to determine how much the goods and services that they offer consumers cost the company, and they can set a price based on the profit margin they want to see as a result.
The basic Cost of Goods Sold (CGS) formula is a universal equation used by businesses all over the globe. Since financial statements are usually prepared month-to-month, and businesses rarely close out their inventory, the remaining inventory (in dollars), from the previous month becomes the beginning inventory, which serves as the first step in the equation. Businesses then take their net purchases for the accounting period and add them to the bottom line, coming up with the available inventory for the period.
Once available inventory is determined, it's time to subtract the ending inventory for the period, which will be carried over into the next period's beginning inventory. The remaining balance leaves you with total CGS, which you can divide out over total sales to find the average cost per unit of production for the period.
Although this equation is very simple, it also has some flexibility to it. Considering price changes, inflation, and general market variances, a firm will not always pay the same price for the raw materials they use. While it may cost a firm $5.00 to produce one unit of something in January, it may cost the firm $6.50 in June, and $8.00 in November to produce the same quantity of the same product. This affects the CGS formula, and can have a major impact on the ending CGS. Firms have a limited ability to manipulate the way they report the ending inventory based on these variances, which affects their CGS and can provide a tax benefit when used properly. The three methods for determining ending inventory are First in, First out (FIFO), Last in, First out (LIFO), and Weighted Average (WAVG)
Under FIFO, the firm assumes that they empty their stock from the oldest inventory to the newest. If, for instance, a firm had 50 items they had purchased at $5.00 per unit left over before they purchased another 50 items at $6.00 per unit, the firm assumes that the 50 older items are sold first. If the business sells 50 items for that month, the Ending Inventory will show the remaining 50 items on the CGS formula as having cost $6.00, making EI for the month $300. FIFO is one of the most commonly used inventory techniques used worldwide in firms today, as many countries prohibit LIFO and WAVG methods, though the United States does not.
Under LIFO, the firm assumes that their stock is emptied from the newest items to the oldest. Under our same scenario, all 50 items purchased in that month would be priced at $6.00, meaning that the EI will be comprised of the older 50 items which cost $5.00, for a total EI of $250 The LIFO technique is most often used in times of inflation, because it allows a firm to artificially reduce their profit margin and reduces income taxes levied on that period.
Finally, under the WAVG technique, a company averages the cost per unit by taking the totals of their Beginning Inventory and their Net Purchases for the period and dividing it by the total number of units in stock. In our scenario, Beginning Inventory is $250 and our Net Purchases are $300, making a total of $550, which we divide by our total available stock (100), and get a Weighted Average price per unit of $5.50. We can then take our month's sales of 50 items and multiply it out to make our WAVG ending inventory cost of $275.
In summary, you can see that FIFO, WAVG, and LIFO produce an Ending Inventory balance of $300, $275, and $250, respectively. Plugging that into our CGS formula will produce a $250 CGS under FIFO, a $275 CGS under WAVG, and a $300 CGS under LIFO
Inventory accounting and manipulating Cost of Goods Sold (CGS)
By: Garett Otterbein
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