 How to Use Financial Reports to Apply Inventory Valuation Methods - dummies

# How to Use Financial Reports to Apply Inventory Valuation Methods

To give you an idea of how inventory can impact the bottom line on financial reports, here is an inventory scenario to take you through the calculations for cost-of-goods value by using the three key methods: average costing, FIFO, and LIFO.

In all three cases, the same beginning inventory is used, purchases, and ending inventory for a one-month accounting period in March.

1. 100 (Beginning inventory) + 500 (Purchases) = 600 (Goods available for sale)

2. 600 (Goods available for sale) – 100 (Ending inventory) = 500 (Items sold)

Three inventory purchases were made during the month:

March 1     100 at \$10

March 15     200 at \$11

March 25     200 at \$12

The beginning inventory value was 100 items at \$9 each.

## Average costing

Before you can use the average costing inventory system, you need to calculate the average cost per unit.

100 at \$9 = \$900 (Beginning inventory)

Plus purchases:

100 at \$10 = \$1,000 (March 1 purchase)

200 at \$11 = \$2,200 (March 15 purchase)

200 at \$12 = \$2,400 (March 25 purchase)

Cost of goods available for sale = \$6,500

Average cost per unit:

\$6,500 (Cost of goods available for sale) ÷600 (Number of units) = \$10.83 (Average cost per unit)

When you know the average cost per unit, you can calculate the cost of goods sold and the ending inventory value pretty easily by using the average costing inventory system:

Cost of goods sold    500 at \$10.83 each    =\$5,415

Ending inventory    100 at \$10.83 each    =\$1,083

So the value of cost of goods sold using the average costing method is \$5,415. This figure is the one you see as the Cost of goods sold line item on the income statement. The value of the inventory left on hand, or the ending inventory, is \$1,083. This number is the one you see as the inventory item on the balance sheet.

## FIFO

To calculate FIFO, you don’t average costs. Instead, you look at the costs of the first units the company sold. With FIFO, the first units sold are the first units put on the shelves. Therefore, beginning inventory is sold first, then the first set of purchases, then the next set of purchases, and so on.

To find the cost of goods sold, add the beginning inventory to the purchases made during the reporting period. The remaining 100 units at \$12 are the value of ending inventory. Here’s the calculation:

Beginning inventory: 100 at \$9 = \$900

March 1 purchase: 100 at \$10 = \$1,000

March 15 purchase: 200 at \$11 = \$2,200

March 25 purchase: 100 at \$12 = \$1,200

Cost of goods sold = \$5,300

Ending inventory:

From March 25: 100 at \$12 = \$1,200

In this example, the cost of goods sold includes the value of the beginning inventory plus the purchases on March 1 and 15 and part of the purchase on March 25. The units that remain on the shelf are from the last purchase on March 25. The cost of goods sold is \$5,300, and the value of the inventory on hand, or the ending inventory, is \$1,200.

## LIFO

To calculate LIFO, start with the last units purchased and work backward to compute the cost of goods sold. The first 100 units at \$9 in the beginning inventory end up being the same 100 at \$9 for the ending inventory. Here’s the calculation:

March 25 purchase: 200 at \$12 = \$2,400

March 15 purchase: 200 at \$11 = \$2,200

March 1 purchase: 100 at \$10 = \$1,000

Cost of goods sold = \$5,600

Ending inventory:

From beginning inventory: 100 at \$9=     \$900

So the Cost of goods sold line item that you find on the income statement is \$5,600, and the Value of the inventory line item on the balance sheet is \$900.

## How to compare inventory methods and financial statements

Income Statement Line Item Averaging FIFO LIFO
Sales \$10,000 \$10,000 \$10,000
Cost of goods sold \$5,415 \$5,300 \$5,600
Income \$4,585 \$4,700 \$4,400

LIFO gives the lowest net income figure and the highest cost of goods sold. Companies that use the LIFO system have higher costs to write off on their taxes, so they pay less in income taxes. FIFO gives companies the lowest cost of goods sold and the highest net income, so companies that use this method know that their bottom line looks better to investors.

Results for the inventory number on the balance sheet also differ using these methods:

Averaging FIFO LIFO
Ending inventory \$1,083 \$1,200 \$900

LIFO users are likely to show the lowest inventory balance because their numbers are based on the oldest purchases, which, in many industries, cost the least. This situation is exactly opposite if you look at an industry in which the cost of goods is dropping in price — then the oldest goods can be the most expensive.

For example, computer companies carrying older, outdated equipment can have more expensive units sitting on the shelves if they try to use the LIFO method, even though the units may not be worth anywhere near what the company paid for them.