CHAPTER 2: Decision-making based on internal cost allocation

CHAPTER 2
LEARNING UNIT 9: Cost flow assumptions and cost formulae
ASSESSMENT CRITERIA
After working through this learning unit, you should be able to record inventory according to the
• first-in-first out (FIFO) method
• weighted average method
• specific identification method

You should spend approximately 4-5 hours on mastering the learning outcomes of this Learning Unit.

9.1 INTRODUCTION

As indicated in Learning Unit 3, a company must, when building a cost accounting system, make a cost
flow assumption from those prescribed by IFRS. Read paragraph 3.2.2.4 again. Based on the cost flow
assumption made, the company will select one of the cost formulae provided for in the accounting
standards. A cost flow assumption means that the management must decide how they ‘picture’ costs
attaching to units of inventory sold (finished goods and merchandise) or issued to production (materials).
The concept cost flow assumption will presently become clear to you. The assumption is made about
costs that flow out of inventory only; the costs flowing into inventory are what they are: the cost of
materials is what we paid for the materials and the cost of finished goods is the total production costs
assigned to the finished goods.
IAS 2.23 states as follows:
The cost of inventories of items that are not ordinarily interchangeable and goods or services produced
and segregated for specific projects shall be assigned by using specific identification of their individual
costs.
This means that, where management makes the assumption that costs attach to specific units, costs
will flow out of inventory with those specific units, and the specific identification cost formula will be
selected.
IAS 2.25 states that:
The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the
first‑in, first‑out (FIFO) or weighted average cost formula. An entity shall use the same cost formula for
all inventories having a similar nature and use to the entity. For inventories with a different nature or
use, different cost formulas may be justified.
IAS 2.27 further states that
The FIFO formula assumes that the items of inventory that were purchased or produced first are sold
first, and consequently the items remaining in inventory at the end of the period are those most recently
purchased or produced. Under the weighted average cost formula, the cost of each item is determined
from the weighted average of the cost of similar items at the beginning of a period and the cost of
similar items purchased or produced during the period.
This means that, where management makes the assumption that costs attached to units that came
into inventory first, flow out of inventory first, regardless of the units that are physically moving out of
inventory, then they must select the FIFO cost formula. If management makes the assumption that an
average cost will flow out of inventory, they will select the weighted average cost formula.
The choice of cost formula is limited to FIFO, weighted average and specific identification. The cost
formula that is selected is important as it will affect the valuation of inventory and therefore also the
cost of sales and profit of the company.

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9.2 CATEGORIES OF INVENTORY

IAS 2. 8 states that

Inventories encompass goods purchased and held for resale including, for example, merchandise
purchased by a retailer and held for resale ... Inventories also encompass finished goods produced, or
work in progress being produced, by the entity and include materials and supplies awaiting use in the
production process…
The categories of inventory are therefore, for manufacturers:
• Inventory of consumables (supplies)
• Inventory of materials (direct and indirect)
• Work-in-Progress inventory
• Finished goods inventory
The categories of inventory held by a retailer are:
• Inventory of consumables (supplies)
• Inventory of merchandise
IAS 2.25 states, among others, that (f)or inventories with a different nature or use, different cost
formulas may be justified.
This means that it will be quite in order to select e.g., a weighted average cost formula for e.g.,
consumables and a FIFO cost formula for the other categories of inventory. For a manufacturer
manufacturing specific, identifiable goods, it would also be in order to adopt e.g., the FIFO method for
materials inventory and the specific identification method for work-in-progress and finished goods. The
discussion that follows is based mainly on the inventory of manufactured finished goods. The same
principles apply to purchased materials and merchandise inventories.

9.3 SPECIFIC IDENTIFICATION METHOD

IAS 2.23 prescribes that inventories that are not interchangeable and goods produced for specific
projects shall apply the specific identification method. Organisations that would use the specific
identification method are e.g., car manufacturers and dealerships, jewellery manufacturers and stores,
art galleries and bespoke furniture manufacturers and stores.
Specific identification implies that the company is able to identify and track each unit of inventory. In a
merchandising operation it should be fairly easy to track individual items of merchandise purchased.
Motor cars, for example, already have unique identity features, such as the vehicle identification
number (VIN). A car's VIN identifies a specific vehicle; one could liken a car's VIN to a human's finger
prints, in that no two vehicles will have the same VIN. The VIN can be used to track factory recalls,
registrations, warranty claims, etc. Given that the VIN appears on the car's dashboard and inside the
driver's door, but also on its registration papers and licence disk; motor vehicles are thus not
interchangeable. Other methods of tracking the movement of items that are unique and not
interchangeable are serial numbers, RFID tags, etc. The tracking system must also be able to track
the cost of each item individually.
The specific identification method matches the flow of costs into and out of inventory attached to the
specific items. The cost of sales and the cost of closing inventory therefore reflect the costs that have
been incurred in the purchase or manufacture of specific items.
Example 9.1
Mumhanzi Ltd manufactures and sells hand-made violins. The company has adopted the specific
identification method as cost formula. The selling price of one violin is R2 270. The transactions relating
to Mumhanzi 's most popular violin, the 4/4 size Kliphuis, for April were:
1 April Inventory on hand from batch 123x: 20 violins @ R961
3 April Sales of 15 violins from batch 123x
12 April Received from work--in-progress on batch 424t: 8 violins @ R1 020
15 April Received from work--in-progress on batch 098e: 17 violins @ R983
20 April Sold 11 violins, 3 from batch 424t and 8 from batch 098e
25 April Received from work--in-progress on batch 111k: 11 violins @ R1 003
30 April Sold 5 violins, 2 from batch 123x and 3 from batch 111k

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The completed inventory card for the Kliphuis appears below:

Movement in inventory Balance in inventory
Date: From / to Ref. Units Unit Total cost Ref. Units Unit Total
April account no. cost (R) No cost cost (R)
1 Balance 123x 20 123x 20 961 19 220
3 COS  123x (15) (961) (14 415) 123x 5 961 4 805
12 WIP 424t 8 1 020 8 160 424t 8 1 020 8 160
15 WIP 098e 17 983 16 711 098e 17 983 16 711
20 COS  424t (3) (1 020) (3 060) 123x 5 961 4 805
424t 5 1 020 5 100
098e 17 983 16 711
20 COS  098e (8) (983) (7 864) 123x 5 961 4 805
424t 5 1 020 5 100
098e 9 983 8 847
25 WIP 111k 11 1 003 11 033 111k 11 1 003 11 033
30 COS 123x (2) (961) (1 922) 123x 3 961 2 883
424t 5 1 020 5 100
098e 9 983 8 847
111k 11 1 003 11 033
30 COS 111k (3) (1 003) (3 009) 123x 3 961 2 883
424t 5 1 020 5 100
098e 9 983 8 847
111k 8 1 003 8 024

Transferred to COS 31 R30 270

Closing inventory 25 R24 854
 15 violins from batch 123x were sold, thus the associated cost is R961 per violin
 3 violins from batch 424t were sold, thus the associated cost is R1 020 per violin
 8 violins from batch 098e were sold, thus the associated cost is R983 per violin
Inventory on hand after each transaction is shown between the double lines.
Unlike the other cost formulae, where assumptions are made about costs flows without regard to the
flow of physical units, the specific identification method looks at the movement of physical units and
the costs attached to those units; the costs and units flow together. In this example we have used
numbers to identify the units. In practice, individual units will each have unique identification, but for
explanatory purposes we have treated the units in batches in this example.
The profit for April was: R
Sales (31 × R2 270) 70 370
Cost of Sales 30 270
Profit for the month 40 100
Journal entries are shown after Example 9.3.
________________________________________________________________________________

9.4 FIRST-IN-FIRST-OUT (FIFO)

This cost formula assumes that the cost of the first units into inventory is assigned to the first units
out of inventory. It does not mean that the actual goods that were manufactured first are physically
sold first; it means that the cost of the goods manufactured first will flow out first. It is possible that the
cost of the goods manufactured first will flow out with the physical units that were manufactured last.
The balance of inventory on hand will therefore always reflect the most recent cost prices. (Sometimes
items of inventory have an expiry date and then of course the goods first in will in all likelihood also
physically be the goods first out.)

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Example 9.2
We use the same information as in Example 9.1, but apply the FIFO cost formula. The inventory card
of the Kliphuis will now appear as follows:

Movement in inventory Balance in inventory

Date: From / to Units Unit Total cost Units Unit Total
April account cost (R) cost cost (R)
1 Balance 20 20 961 19 220
3 COS (15) (961) (14 415) 5 961 4 805
12 WIP 8 1 020 8 160 8 1 020 8 160
15 WIP 17 983 16 711 17 983 16 711
20 COS  (5) (961) (4 805) 2 1 020 2 040
20 COS  (6) (1 020) (6 120) 17 983 16 711
25 WIP 11 1 003 11 033 2 1 020 2 040
17 983 16 711
11 1 003 11 033
30 COS  (2) (1 020) (2 040) 14 983 13 762
30 COS  (3) (983) (2 949) 11 1 003 11 033

Closing inventory 25 24 795

 Of the 11 units sold, 5 were assumed to be from the oldest inventory at a cost of R961 each;
the remaining 6 were assumed to be from the second oldest inventory at a cost of R1 020 each.
 Of the 5 units sold, 2 were assumed to be from the oldest inventory at a cost of R1 020 each,
the remaining 3 were assumed to be from the second oldest inventory at a cost of R983 each.
The profit for April was: R

Sales 70 370 (31 × R2 270)

Cost of Sales 30 270 (14 415 + 4 805 + 6 120 + 2 040 + 2 949)
Profit for the month 40 041
Journal entries are shown after Example 9.3.
________________________________________________________________________________

During times of inflation the use of the FIFO method will result in issues of materials to production
being made at the oldest, ‘‘cheaper’’ prices. Profits will therefore be higher until issues take place at
the later "more expensive" price. The opposite will happen in times of deflation (price decreases).

In the above examples, receipts and issues of inventory are shown in the same columns. The inventory
account may also be shown with separate columns for receipts and issues, as below:

I n v e n t o r y c a r d : p u m p s
Date R e c e i p t s I s s u e s B a l a n c e
Apr Quantity Price Amount Quantity Price Amount Quantity Price Amount
R R R R R R
1 20 961 19 220
3 15 961 14 415 5 961 4 805
12 8 1 020 8 160 8 1 020 8 160
15 17 983 16 711 17 983 16 711
20 5 961 4 805 2 1 020 2 040
6 1 020 6 120 17 983 16 711
21 (1) (983) (983) 7 1 020 7 140
(5) (1 020) (5 100) 16 983 15 728

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Returns
When purchased goods are returned to the supplier, the cost attached to the goods returned is the
actual cost, because that is what the supplier will issue a credit note for. Assume that the above
inventory card is for a direct material. "pumps".
• On 21 April a pump that was purchased on 15 April was returned to the supplier. Notice how,
instead of showing the return as an issue, it is shown as a negative receipt. Note also that, despite
the application of FIFO, the return is shown at its actual cost of R983. This is necessary because
that is the amount that the supplier will issue a credit note for. The relevant journal entry will be:
Dr Supplier with R983 and Cr Inventory of Materials with R983.
• on 21 April the factory returned 5 pumps that it had requisitioned on 3 April. Returns from the
factory, i.e., in-house returns, are assumed to be from the last issues, thus keeping their cost as
recent as possible. Regardless of the cost at which the pump was issued, it is assumed that the
pumps were returned from the latest issue, i.e., 20 April. Even though the pumps were actually
issued at R961 each, they are received back in the store at R1 020. The journal entry will be:
Dr Inventory of Materials with R5 100 and Cr Work-in-Progress with R5 100.
What is important is that returns to suppliers are treated as negative purchases and returns from the
factory are treated as negative issues.

9.5 WEIGHTED AVERAGE

The weighted average method assumes costs flow at averaged unit costs, which are updated after
every receipt of goods or materials into the stores.
Example 9.3
We use the same information as in Example 9.1, but apply the weighted average cost formula. The
inventory card of the Kliphuis will appear as follows:

Movement in inventory Balance in inventory

Date: From / to Units Unit Total cost Units Unit Total cost
April account cost (R) cost (R)
1 Balance 20 20 961,00 19 220
3 COS (15) (961) (14 415) 5 961,00 4 805
12 WIP  8 1 020 8 160 13 997,31 12 965
15 WIP  17 983 16 711 30 989,20 29 676
20 COS  (11) (989,20) (10 881,20) 19 989,20 18 794,80
25 WIP 11 1 003 11 033 30 994,26 29 827,80
30 COS (5) (994,26) (4 971,30) 25 994,26 24 856,50

Closing inventory 25 24 856,50

 New total cost is 4 805 + 8 160 = R12 965; new unit cost is 12 965 / 13 = 997,30769 ≈ R997,31
 New total cost is 12 965 + 16 711 = R29 676; new unit cost is 29 676 / 30 = R989,20
 COS is calculated at the latest cost per unit in inventory
The profit for April was: R
Sales 70 370,00 (31 × R2 270)
Cost of Sales 30 267,50 (14 415 + 10 881,20 + 4 971,30)
Profit for the month 40 102,50
________________________________________________________________________________

The journal entries for the transactions in Examples 9.1 to 9.3 appear below:

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Example 9.1 Example 9.2 Example 9.3

Specific ID FIFO Weighted average
April R R R R R R
3 Dr Cost of Sales 14 415 14 415 14 415,00
Cr Finished goods inventory 14 415 14 415 14 415,00

12 Dr Finished goods inventory 8 160 8 160 8 160,00

Cr Work-in-progress 8 160 8 160 8 160,00

15 Dr Finished goods inventory 16 711 16 711 16 711,00

Cr Work-in-progress 16 711 16 711 16 711,00

20 Dr Cost of Sales 10 924 10 925 10 881,20

Cr Finished goods inventory 10 924 10 925 10 881,20

25 Dr Finished goods inventory 11 033 11 033 11 033,00

Cr Work-in-progress 11 033 11 033 11 033,00

30 Dr Cost of Sales 4 931 4 989 4 971,30

Cr Finished goods inventory 4 931 4 989 4 971,30

Postings into inventory  35 904 35 904 35 904,00

Postings out of inventory  30 270 30 329 30 267,50
Opening inventory 19 220 19 220 19 220,00
Closing inventory 24 854 24 795 24 856,50
55 124 55 124 55 124 55 124 55 124,00 55 124,00
 The total cost flows into inventory are the same, regardless of the method employed, because
the cost of purchasing/manufacture is what it is, irrespective of the cost formula.
 The total cost flows out of inventory differ, based on the cost flow assumption made and related
cost formula applied.
The weighted average method, after every new receipt of inventory, divides the total cost of all units in
inventory by the number of units on hand at that time to find the new average cost per unit. This average
cost will not change until new goods are received, when a new average will be calculated. A new
average will also be calculated after each return to a supplier or from the factory.
Because inventory systems are computer-based, the unit cost is often kept at three decimals or more
and the total rounded to two decimals. This will result in smaller rounding differences.
Note that Examples 9.1 to 9.3 do not reflect rising prices; unit costs flowing into finished goods were,
chronologically, R961, R1 020, R983 and R1 003.

ACTIVITY 9.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 When inventory turnover is high, the weighted-average and FIFO methods will produce very
similar unit costs in closing inventory.
1.2 If closing inventory is overstated at the end of the year, the net income for the year is also
overstated.
1.3 If closing inventory at the end of the year is understated, then the cost of sales for the is also
understated.
1.4 The value of closing inventory applying the FIFO cost formula more closely approximates current
cost than the weighted average cost formula.
1.5 During periods of rising costs, FIFO generally results in a higher cost of goods sold.
1.6 During periods of rising costs, the cost of sales reported for the year will be lower if the FIFO
cost formula is applied than if the weighted average cost formula is applied.

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QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 The cost formula that results in a new per unit cost after each receipt of inventory is called the
… method.
(a) weighted average
(b) FIFO
(c) specific identification
(d) None of the above
2.2 A disadvantage of the FIFO method of inventory cost flow is that …
(a) physical issues must follow the same order as physical receipts.
(b) one issue may have to be split between two or more different receipts.
(c) jobs started on the same day must be issued with inventory from the same delivery.
(d) it requires an analysis of deliveries that specific issues have been obtained from.
2.3 The specific identification method of inventory valuation is based on the …
(a) latest cost of each item of inventory.
(b) average cost of each item of inventory.
(c) earliest cost of each item of inventory.
(d) actual cost of each item of inventory.
2.4 The use of the FIFO method of inventory valuation results in …
(a) a matching of current inventory costs against sales revenue.
(b) the most current costs in ending inventory.
(c) a lowest reported net income in a time of rising prices.
(d) highest reported net income in a time of falling prices.
2.5 During inflationary periods, the value of closing inventory of a perpetual inventory system and
a periodic inventory system would be same if … cost formula is applied.
(a) neither FIFO nor weighted average
(b) the FIFO
(c) both FIFO and weighted average
(d) the weighted average
2.6 1st March: Opening inventory: 2 unit × R20
2nd March: Purchases: 2 units × R25
3rd March: Sales: 1 unit
Applying the weighted average cost formula to the above information, the cost of sales would
be …
(a) R20.
(b) R22,50.
(c) R25.
(d) R20 or R25, depending on the actual unit taken from inventory.
2.7 A company had 4 000 units of a direct material component with a total cost of R28 000 in
inventory at the beginning of the month. Another 10 000 components were purchased during
the month at a cost of R9 each. The value of the inventory of 3 000 units at the end of the month,
using the FIFO cost flow assumption, is …
(a) R27 000.
(b) R32 000.
(c) R24 000.
(d) R21 000.

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2.8 The weighted average cost of an inventory item is calculated by dividing the …
(a) sum of the unit cost on the purchase invoices by the number of units purchased.
(b) cost of goods available for sale by the number of units in closing inventory.
(c) cost of goods available for sale by the number of units available during the period.
(d) cost of goods sold by the number of units available during the period.
2.9 The following purchases of a direct material component were made during April:
- 10th 200 components at R5,00
- 20th 500 components at R10,00
- 30th 800 components at R15,00
There was no opening inventory. Of the 500 components in closing inventory, 100 components
were purchased on the 10th, 300 components on the 20th and 100 components on the 30th.
Assuming the specific identification method is used, then cost of sales for April would be …
(a) R13 000.
(b) R4 000.
(c) R7 500.
(d) R5 000.
2.10 A company purchased the following raw materials during June:
1st - 150 units R1 040
10th - 200 units R1 560
15th - 200 units R1 680
28th - 150 units R1 320
There was no inventory of the raw material at the beginning of June. A physical count of the raw
material on 30 June showed that there were 210 units on hand. Using the FIFO cost formula,
the value of closing inventory is …
(a) R1 456.
(b) R1 508.
(c) R1 824.
(d) R1 848.

QUESTION 3

Sweet Tooth had 500 units of chocolates in inventory at a unit cost R5. A further 300 chocolates were
transferred into inventory at a total cost of R2 400. It then sold 600 chocolates for R10 each and made
a gross profit of R2 700.
REQUIRED
State which cost formula did Sweet Tooth adopt? Your answer must be supported by appropriate
calculations.

QUESTION 4

Gobiqolo Ltd recorded the following purchases and issues for the material ‘‘Smile’’ for the month of
November:

Date Transaction details

November
01 Opening inventory 500 units @ R5,50
02 Purchased 2 500 units @ R5,80
06 Issued 1 000 units to production
10 Purchased 3 000 units @ R6,00
15 Issued 500 units to production
20 Production returned 200 units issued on 15 November to the store
26 Issued 2 700 units to production
30 Returned 250 units purchased on 10 November to the supplier

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REQUIRED
4.1 Calculate the value of closing inventory on 30 November, using the FIFO cot formula.
4.2 Calculate the cost of materials issued to production.
4.3 Show the journal entries for recording the transactions of 20 November and 30 November.

QUESTION 5

The following transactions for materials item number 555 took place at Eureka Ltd during September:

Date Transaction Details

1 Opening inventory 1 000 units @ R7,00 per unit
5 Purchased 2 500 units @ R7,05 per unit
7 Issued to production 600 units
10 Purchased 1 400 units @ R7,15 per unit
11 Issued to production 500 units
13 Issued to production 2 400 units
17 Returned from production – from the
issue of 7 September 100 units
21 Received an invoice 400 units for R3 200
Freight charges R80
22 Returned to supplier (invoice of 10/09) 200 units
REQUIRED
Calculate the value of inventory on 22 September, using the weighted average cost formula. Round
calculations to three decimal places.

QUESTION 6 - THIS IS A FORUM DISCUSSION QUESTION – see 6.5 below

Ye Olde Shoppe, an antiques dealer, had the following items in inventory at the beginning of the
month:
Description Smart label ID Cost (R)
1 Italian walnut monk's bench 193827 24 190
19th century Cape stinkwood and riempies bank 739027 21 900
Mahogany Chaise lounge 420839 19 400
Stinkwood ball and claw day bed 069352 8 980
Set of 8 Cape neo-classical stinkwood chairs 287412 26 800
19th century giltwood mirror 610312 28 700
129 970

During the month the following items were bought at auction and tagged by smart label:
R Label
18th century French walnut armoire 42 900 438561
19th century Flemish octagon Renaissance table 52 480 092718
19th century German carved oak cabinet 48 620 312685

Delivery charges paid was R7 200

The following restoration work by experts was carried out during the month:
Labour: 130 hours × R500 per DLH R65 000
Special mellow wax (clear) R2 500
Other expenses incurred R1 400

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Items tagged in the workshop:

193827 30 hours
420839 20 hours
069352 35 hours
438561 28 hours
610312 17 hours

At the end of the month the following items were still in inventory:
193827
069352
092718
312685
610312

Total sales for the month amounted to R202 400. Ye Olde Shoppe applies the specific identification
cost formula.
REQUIRED:
6.1 Journal the transactions for the month;
6.2 Show the inventory account in the general ledger;
6.3 Prepare a list of items in inventory, with their cost, as at the end of the month;
6.4 Calculate the gross profit for the month.
6.5 Discuss in the forum practical examples where the specific identification method is adopted.

Clearly show all calculations.

9.6 SUMMARY

In this learning unit, we looked at the three cost formulae allowed by IAS 2 and how they are based on
different assumptions of cost flows. We learned that the value of goods received will always be the
same, regardless of the cost formula used, and that the cost flow assumption relates to the flow of
costs out of inventory (paragraphs 9.1 and 9.2).

We learned that the specific identification method requires the ability to track physical units of inventory
and the costs associated with them, and that for this method physical units and their costs cannot be
separated (paragraph 9.3).

We saw that, for FIFO, the physical units can be separated from their costs and that the principle of
first in first out applies to the costs and not the units (paragraph 9.4). In paragraph 9.4 we also explained
the treatment of inventory returns from the warehouse to the supplier and from the factory to the
warehouse.

The last method considered was the weighted average, where a new, average unit cost is calculated
after each receipt of goods (paragraph 9.5). In this same paragraph, we explained the journal entries
for the receipt and issue of inventory under each of the three methods.

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