CHAPTER 11

INVENTORY
COST FLOW
GROUP 11
 TECHNICAL
KNOWLEDGE

TO IDENTIFY THE COST FORMULAS REQUIRED BY IFRS.

TO APPLY THE FIFO COST FORMULA.
TO APPLY THE WEIGHTED AVERAGE COST FORMULA.
TO APPLY THE MOVING AVERAGE COST FORMULA.
TO APPLY THE SPECIFIC IDENTIFICATION METHOD.
 COST FORMULAS

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using
either:

a. First in, First out

b. Weighted average

The standard does not permit anymore the use of the last in, first out (LIFO) as an alternative formula
in measuring cost of inventories.
 FIRST IN, FIRST OUT
The FIFO method assumes that "the goods first purchased are first sold" and consequently the goods remaining in the inventory at the
end of the period are those most recently purchased or produced.

In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods are sold in the order they are
purchased.

The rule is "first come, first sold"

The inventory is thus expressed in terms of recent or new prices while the cost of goods sold is representative of earlier or old prices.

This method favours the statement of financial position in the inventory is stated at current replacement cost.
The objection to the method is that there is improper matching of cost against revenue because the goods sold are stated at earlier or
older prices resulting in understatement of cost of sales.

Accordingly, in a period of inflaton or rising prices, the FIFO method would result to the highest net income.

However, in a period of defilation or declining prices, the FIFO method would result to the lowest net income.
Illustration - FIFO
The following data pertain to an inventory item.
FIFO - Periodic
Cost of good sold
 FIFO - Perpetual
This requires the preparation of stock card.
 NOTA BENE
Note well that under FIFO-periodic and FIFO-perpetual, the inventory costs are the same. In both cases,
the January 31 inventory is P152,000.

The cost of goods sold is determined from the stock card as follows:
 WEIGHTED AVERAGE
- PERIODIC
The cost of the beginning inventory plus the total cost of purchases during the period is divided by the total units purchased plus
those in the beginning inventory to get a weighted average unit cost.

Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value.

In other words, the average unit cost is computed by dividing the total cost of goods available for sale by the total number of units
available for sale.

The preceding illustrative data are used.

COST OF GOOD SOLD
 WEIGHTED AVERAGE
- PERPETUAL
When used in conjunction with the perpetual system, the weighted average method is popularly known as the moving average
method.

PAS 2, paragraph 27, provides that the weighted average may be calculated on a periodic basis or as each additional shipment is
received depending upon the circumstances of the entity.

Under this method, a new weighted average unit cost must be computed after every purchase and purchase return.

Thus, the total cost of goods available after every purchase and purchase return is divided by the total units available for sale at this
time to get a new weighted average unit cost.

Such new weighted average unit cost is then multiplied by the units on hand to get the inventory cost.

This method requires the keeping of inventory stock card in order to monitor the "moving" unit cost after every purchase.
 WEIGHTED AVERAGE
- PERPETUAL

Observe that a new weighted average unit cost is computed after every purchase.

Thus, after the January 18 purchase, the total bost of P207,000 Bnded by 1000 units to get a weighted average unit cost of P207.

After the January 31 purchase, the total cost of P151,400 is divided by 700 units to get a new weighted average unit cost of P216.
 COST OF GOODS SOLD
FROM THE STOCK CARD

Cost of goods sold The argument for the weighted average method is that it is relatively easy to apply, especially with computers.
Moreover, the weighted average method produces inventory valuation that approximates current value if there is a rapıd turnover of
inventory.

The argument against the weighted average method is that there may be a considerable lag between the current cost and inventory
valuation since the average unit Cost involves early purchases.
 LAST IN, FIRST OUT(LIFO)
The LIFO method assumes that "the goods last purchased are first sold" and consequently the goods remaining in the inventory at the end
of the period are those first purchased or produced.

The inventory is thus etpresed in terms of earlier or old prices and the cost of goods sold is representative of recent or new prices.

The LIFO favors the income statement because there is matching of current cost against current revenue, the cost of goods sold being
expressed in terms of current or recent cost.

The objection of the LIFO is that the inventory is stated at earier or older prices and therefore there may be a significant lag between
inventory valuation and current replacement cost.

Moreover, the use of LIFO permits income manipulation, suen as by making year-end purchases designed to preserve exista inventory
layers. At times these purchases may not even be in the best economic interest of the entity.

Actually, in a period of rising prices, the LIFO method would result to the lowest net income. In a period of declining prices, the LIFO
method would result to the highest net income.
 LIFO - Periodic
In the preceding illustration, the cost of 700 units under the LIFO is computed as follows:
Cost of goods sold under LIFO - periodic
 LIFO - Perpetual
This requires the preparation of stock card.

Note well that LIFO-periodic and LIFO- perpetual differ in inventory value.

Under LIFO periodic , the January 31 inventory is P140,000 and under LIFO perpetual, the January 31
inventory is P150,000.
Another illustration
 FIFO - whether periodic or perpetual

The January 30 purchase of 16,000 units is reduced by the purchase return of 2,000 units or net purchase of 14,000
units. Note that under FIFO perpetual, the sale return of 1,000 units on january 16 would be costed back to
inventory at the latest purchase unit cost of P250 before the sale.
Moving average - Perpetual

Observe that the moving

average unit cost changes every
time there is a new purchase or
a purchase return. The moving
average unit cost is not affected
by a sale or a sale return.
Weighted average - Periodic
 SPECIFIC IDENTIFICATION
Specific identification means that specific costs are attributed to identified items of inventory.

The cost of the inventory is determined by simply multiplying the units on hand by their actual unit cost.

This requires records which will clearly determine the actual costs of goods on hand.

PAS 2, paragraph 23, provides that this method is appropriate for inventories that are segregated for a specific project and inventories that are
not ordinarily interchangeable.

The specific identification method may be used in either periodic or perpetual inventory system.

The major argument for this method is that the flow of the inventory cost corresponds with the actual physical flow of goods.

With specific identification, there is an actual determination of cost of units sold and on hand.

The major argument against this method is that it is very costly to implement even with high-speed computers.
 STANDARD COSTS
Standard costs are predetermined product costs established on the basis of normal levels of materials and supplies, labor, efficiency and
capacity utilization.

Observe that a standard cost is predetermined and, once determined, is applied to all inventory movements inventories, goods available for
sale, purchases and goods sold or placed in production.

PAS 2, paragraph 21, states that the standard cost method may be used for convenience if the results approximate cost.

However, the standards set should be realistically attainable and are reviewed and revised regularly in the light of current conditions.

Standard costing is taken up in a higher accounting course and is not discussed further in this book.
 RELATIVE SALES PRICE
METHOD
When different commodities are purchased at a lump sum, the single cost is apportioned among the commodities based on their respective
sales price. This is based on the philosophy that cost is proportionate to selling price.

For example, products A, B, and C are purchased at "basket price" of P3,000,000. Assumne that the said products have the following sales
price: A P500,000, B P1,500,000, and C P3,000, 000.
 QUESTIONS
1. What are the cost formulas in measuring the cost of inventory?
2. Explain FIFO.
3. Explain weighted average method.
4. Explain moving average method.
5. Explain specific identification.
6. When is specific identification method appropriate in determining cost of inventory?
7. Explain LIFO.
8. Is LIFO allowed in measuring the cost of inventory.
9. Explain standard costs.
10. Explain the relative sales price method of allocating inventory cost.