Over the years, the accounting profession hasn’t managed to settle on just one method for recording cost of goods sold and inventory cost [for unique products]. Different methods have been allowed for many years. A business is entirely at liberty to choose whichever method it wishes from among the generally approved methods, which are as follows:
- Average cost method: The costs of different batches of products are averaged to determine cost of goods sold expense and ending inventory cost.
- First-in, first-out (FIFO) method: The costs of batches are charged to cost of goods sold in the order the batches are acquired, and the cost of ending inventory is from the most recent batch(es) acquired.
- Last-in, first-out (LIFO) method: The costs of batches are charged to cost of goods sold in the reverse order that the batches were acquired, and the cost of ending inventory is from the oldest batch(es) acquired.
The one universal rule is that a business can’t mark up its ending inventory [that is, its stockpile of unsold products on hand at the end of the year] to the current replacement cost values of the products. In short, GAAP doesn’t allow market value appreciation of inventory to be recorded.
Determining Whether Products Are Unique OR Fungible
In deciding on its cost of goods sold method of accounting, the first step a business does is to determine whether the products it sells are fungible OR unique:
- A unique product is the only one of its kind; no other product is like it in all respects. For example, given the wide range of options, equipment, colors, and models, every car on the lot of a new auto dealer may be different. Another example of a business that sells unique products is a jeweler that sells high priced rings, necklaces, brooches, and so on. Each piece is different than the others.
- Fungible means that products are interchangeable and virtually indistinguishable from one another. The products may have different serial numbers, but customers are indifferent regarding which specific products they receive. Most products you buy in a grocery store or fungible. The iPods that Apple sells are fungible. Apple sells different models of iPods, but within each model category the products are fungible.
When the products it sells are unique, the business uses the specific identification method to record cost of goods sold expense. The business keeps a separate record for the cost of each product. The cost of each product is charged to cost of goods sold expense when that particular product is sold.
Generally speaking, unique (non-fungible) products are higher priced than fungible products. Also, unique products are bought one at a time, whereas fungible products are bought in batches. The cost per unit of each successive batch typically fluctuates over time. This poses a dilemma; the business must choose which accounting method to use for recording cost of goods sold, which the next section explains.
Let’s assume a business made five purchases during the year. It bought 100,000 units of the one product it sells at $ $3,725,000. Suppose, further, that the cost per unit in all five purchases was the same. In other words, there was no change in the purchase cost per unit during the year. This is not too likely, but this scenario provides is a good jumping off point for explaining cost of goods sold. During the year, the business sold 80,000 units of product. The revenue from these sales was $4,585,000.
The question is: What amount of gross profit (margin) did the business earn from sales of products during the year?
To determine gross profit, you must first determine the cost of the 80,000 units sold during the year. In this scenario the purchase cost per unit of the products sold by the business remained constant during the year.
So, there is only one method to determine cost of goods sold: (80,000 units sold/100,000 units purchased x $3,725,000 cost of purchases = $2,980,000 cost of goods sold). In other words, 80 percent of the goods purchased and available for sale were sold during the year and, therefore, 80 percent of the total cost of purchases should be charged to cost of goods sold.
The following journal entry is made:
Sales revenue = $4,585,000
Minus: Cost of goods sold expense = $2,980,000
Equal: Gross margin = $1,605,000
The cost per unit of products purchased [or manufactured] usually does not stay the same from batch to batch. Usually the cost per unit fluctuates from batch to batch. This fluctuation creates an accounting problem. Three different methods are used to deal with the fluctuation of cost per unit from batch to batch, which I explain in the following sections.
Average Cost Method
Many accountants argue that when the acquisition cost per unit fluctuates the thing to do is to use the average cost of products to determine cost of goods sold. The logic of the average cost method goes like this:
Five batches of products were purchased at different prices, so it’s best to lump together all five purchases and determine the average cost per unit. Using the previous example, the average cost per unit purchased during the year is calculated as follows:
$3,725,000 total cost of purchases / 100,000 units = $37.25 average cost per unit
The cost of goods sold for the products sold during the year is calculated as follows:
80,000 units sold during year × $37.25 average cost per unit = $2,980,000 cost of goods sold
Alternatively, if you know that the business sold 80,000 of the 100,000 units available during the year you can calculate cost of goods sold the following way:
[80,000 / 100,000] × $3,725,000 total cost of purchases = $2,980,000 cost of goods sold
You should have noticed that the average cost method gives the same answer for cost of goods sold expense as in the example scenario just above in which it is assumed that the purchase cost per unit remained the same during the year. That’s the effect of calculating an average. The five different costs per unit figures are condensed to one average number, as if this had been the cost per unit during the year.
Using the average cost method, the $37.25 average cost per unit is used for the company’s 20,000 units of ending inventory (100,000 units acquired less 80,000 units sold):
20,000 units of inventory × $37.25 average cost per unit = $745,000 cost of ending inventory
Summing up: the $3,725,000 total cost of products purchased during the first year of business is divided between $2,980,000 cost of goods sold and $745,000 cost of ending inventory.
The average cost method is not as easy to use in actual practice as this example may suggest. With this method, you face questions such as how often should you determine the average cost per unit? Should you calculate the average just once a year, once each quarter, or once each month? Before computers came along, calculating an average cost per unit was a pain in the posterior.
The First-In, First Out [FIFO] method
My Uncle Andrew worked many years on the receiving and shipping docks of several businesses. If you asked Andrew how to calculate the cost of goods sold, he would point out that the first goods into inventory are the first to be delivered to customers when products are sold. In other words, the sequence follows a first-in, first-out order. Businesses don’t buy an initial stock of products, put them away in a dark corner, and then take a long time to deliver these products to customers. [Well, wineries may be an exception to this general rule].
The first-in, first-out flow of products delivered to customers means that the business’s inventory of products at the end of the year comes from its most recent purchase(s). The first-in, first-out (FIFO) method of determining cost of goods sold expense follows the flow of products taken out of inventory for delivery to customers.
In internal accounting reports to managers, the accountant presents the cost per unit sold and compares it with the sales price during the year to determine the profit margin per unit.
The cost per unit sold doesn’t equal any of the five acquisition costs, nor does it equal the average cost per unit purchased during the year, which is $37.25. Business managers are used to dealing with averages, so this discrepancy shouldn’t be a problem — although, whenever you’re dealing with an average, it’s important to know and take into account how the average is determined.
What about ending inventory? By the FIFO method, the cost of ending inventory equals the cost of the most recent acquisition(s) — because the cost of earlier acquisitions are charged to cost of goods sold expense for the year.
The LIFO method
The FIFO method [see the preceding section] has a lot going for it: It follows the actual sequence of products delivered out of inventory to customers, and it’s relatively straightforward to apply. But, federal income tax law [USA] allows businesses to use an opposite method to determine annual taxable income. This feature of the tax law has led to the widespread adoption of the method, called last-in, first-out, or LIFO. The method reverses the sequence in which products sold are removed from inventory and charged to cost of goods sold expense.
As with the FIFO method, the LIFO average cost per unit sold doesn’t equal any of the five acquisition costs, nor does it equal the average cost per unit purchased during the year, which is $37.25. Business managers are used to dealing with averages, though, so this discrepancy shouldn’t be a problem. However, whenever dealing with an average, it is important to know how the average is determined and take that information into account.
What about ending inventory? The ending inventory value by the LIFO method depends on whether the business during the year increased the number of products held in inventory.
Assume that the business did in fact increase its quantity of inventory [it acquired more units than it sold during the year]. In this case, the cost of ending inventory equals the cost of its beginning inventory and the cost of the additional units, which is based on the per unit costs from the earliest acquisitions during the year. On the other hand, when a business decreases its inventory during the year its ending inventory cost is based on the cost(s) per unit in its beginning inventory.
Comparing the Three Methods
FIFO gives a more up-to-date inventory cost in the balance sheet. But, nevertheless, many businesses use LIFO because it minimizes taxable income in their federal income tax returns [assuming an inflationary trend of acquisition costs over time]. Reporting ending inventory based on the earliest acquisition cost is the Achilles’ heel of the LIFO method.
Assume a business has been using LIFO for, say, 40 years. This means that some part of its inventory cost goes back to costs it paid 40 years ago. [As a matter of fact, Caterpillar Inc. has been using LIFO for more than 50 years]. If the difference between the current cost value of inventory [as measured by FIFO] and the LIFO cost is significant the business discloses this discrepancy in a footnote to its financial statements