Merchandisers purchase assets (inventory) to resell for a profit. Under a periodic inventory system, inventory is counted at the end of the fiscal period to determine cost of goods sold and gross margin.

Beginning Inventory
+ Net Cost of Purchases
= Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold

If Ending Inventory is understated, cost of goods sold is overstated, and Gross Margin, and therefore Net Income, is understated.

If Ending Inventory is overstated, cost of goods sold is understated, and Gross Margin, and therefore Net Income, is overstated.

Under a periodic system , when inventory is purchased, that purchase is recorded at historical cost. But when inventory is sold, no transaction is recorded to recognize the outflow of assets. Instead, that expense is not recognized until the end of the fiscal period when inventory items are counted, and then costs are assigned to those items. Under generally accepted accounting principles, there are four acceptable methods to assign those cost to the ending units of inventory.

The Specific Identification method isolates actual individual unit cost to units of ending inventory. For instance, an automobile dealer knows the cost of each vehicle on their lot. To calculate dollars of ending inventory then, the dealer simply totals those cost of each vehicle.

The Average Cost method blends the costs of beginning inventory and purchases to determine the value of ending inventory. To apply the average cost method, divide Goods Available for Sale (Beginning Inventory $ + Net Purchases $) by the number of units of inventory available for sale. That will determine an average cost per unit. Then, multiply that average cost per unit to the units of ending inventory to determine the total value of ending inventory.

Here is an example, using the Average Cost method:

Sales	280 units @ $20 per unit		$5,600
Beginning Inventory	100 units @ $10 per unit	$1,000
Purchase #1	120 units @ $11 per unit	$1,320
Purchase #2	160 units @ $13 per unit	$2,080
Purchase #3	100 units @ $16 per unit	$1,600
Goods Available for Sale	480 units	$6,000
Ending Inventory	200 units @ $12.50 per unit	$2,500
Cost of Goods Sold			$3,500
Gross Margin			$2,100

Using the Average Cost Method, Dollars of Goods Available for Sale is divided by Units of Goods Available for Sale to determine a cost per unit. In the above example, average cost = $6,000/480 = $12.50 per unit. Then, the units of ending inventory are multiplied by that average cost per unit to determine the dollar value of ending inventory. So, 200 units of ending inventory (480 units available for sale less the 280 units sold) x $12.50 per unit = $2,500. Then, Goods Available for Sale less Ending Inventory equals Cost of Goods Sold, and Sales less Cost of Goods Sold equals Gross Margin.

The Average Cost Method blends the changes in per unit inventory costs that were incurred during the period, and therefore tends to ignore any trend in cost increases or decreases.

The next method we'll discuss is the FIFO method - "First in, first out". FIFO assumes that the merchandiser sells oldest units first. To picture this, think about how cartons of milk are stocked and then sold at your local supermarket. The merchant pushes the oldest milk cartons to the front of the dairy case (turning them around so that you can't see the date), and then stocks the newer cartons in the rear. Therefore, customers tend to purchase the earliest items of inventory. Therefore, the ending inventory is comprised of units from the latest purchases.

Again the example from before, using FIFO:

Sales	280 units @ $20 per unit		$5,600
Beginning Inventory	100 units @ $10 per unit	$1,000
Purchase #1	120 units @ $11 per unit	$1,320
Purchase #2	160 units @ $13 per unit	$2,080
Purchase #3	100 units @ $16 per unit	$1,600
Goods Available for Sale	480 units	$6,000
Ending Inventory	200 units = 100 units @ $16 + 100 units @ $13	$2,900
Cost of Goods Sold			$3,100
Gross Margin			$2,500

When using FIFO, ending inventory is valued using newer, and in this case, higher costs. Therefore, because the cost of ending inventory is higher, cost of goods sold is lower, and gross margin is higher. FIFO overstates net income in periods of inflation, matches oldest costs against current revenues, but ending inventory figure reflects current costs.

The LIFO method assumes the opposite direction of cost flow. Using LIFO, the assumption is that the merchandiser sells the latest purchases first - "Last in, first out" - and therefore ending inventory is comprised of units from the earliest purchases. To picture this, think about how sand is stored at a building supply merchandiser. Generally, the sand is stored in a large pile on the ground. When the merchant purchases more sand inventory, a dump truck comes and dumps brand new sand on top of the old sand. When a customer buys sand, they take new sand from the top of the pile, and leave the old sand on the bottom, ostensibly to age, but also to be counted as ending inventory.

One more time, our example, using LIFO:

Sales	280 units @ $20 per unit		$5,600
Beginning Inventory	100 units @ $10 per unit	$1,000
Purchase #1	120 units @ $11 per unit	$1,320
Purchase #2	160 units @ $13 per unit	$2,080
Purchase #3	100 units @ $16 per unit	$1,600
Goods Available for Sale	480 units	$6,000
Ending Inventory	200 units = 100 units @ $10 + 100 units @ $11	$2,100
Cost of Goods Sold			$3,900
Gross Margin			$2,100

When using LIFO, ending inventory is valued using older, and in this case, lower costs. Therefore, because the cost of ending inventory is lower, cost of goods sold is higher, and gross margin is lower. Compared to FIFO, LIFO understates net income in periods of inflation, and the ending inventory figure reflects older costs. LIFO matches current costs of inventory against current income, which is consistent with the AICPA's goals of inventory measurement, which notes "A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues." And, it is important to note that we are trying to match costs with revenues, not match the flow of actual goods through an inventory system!

From a theoretical standpoint LIFO's advantage is that "proper matching", while FIFO's advantage is the production of an up-to-date calculation of inventory costs. Given the AICPA's policy, the matching rule takes precedence here!

Okay, we need some practice with this stuff. Next time, let's discuss Portia’s Part Shop (exercise #2A on page #290), and purchases and sales of parts.

Clifford