Inventory Cost Flow Assumptions

In our previous lesson we learnt how to calculate total cost of inventory. Once inventory is acquired or processed they are stored in warehouses from where they are sent to customers or production hall for further processing.



When inventory is issued either for sales or production we need to divide the cost between inventory consumed/sold and inventory still at hand. It is fairly easy to compute if there is only one type of inventory with one cost.

For example there were 100 units in the store with the total cost of 1000. This gives cost of 10/unit. If 40 units have been issued to production hall then value of inventory sent for production is 400. Whereas value of inventory still in the store is 600.

Situation however becomes confusing if we have similar inventory but with varying cost. For example an entity has 100 units in store that were purchased over a period of time with following details:

30 units with price per unit 10 = $300
40 units with price per unit 12 = $480
30 units with price per unit 11 = $330

If entity has issued 50 units to production hall, what is the value of inventory sent for production and inventory still at store?

Should it be 30 units @ $10/unit + 20 units @ $12/unit; or
Should it be 40 units @ $12/unit + 10 units @ $11/unit; or
Should it be any other combination?

To avoid such confusion while assigning cost, entity may use a specific cost formula to determine value of inventory issued to sales department or production department and the inventory held by the entity in store at the end of the period.

Following are some of the widely known methods:

  1. First In First Out (FIFO)
  2. Last In First Out (LIFO)
  3. Average Value of Cost (AVCO)
  4. Specific Identification

1 First in First Out (FIFO) Method

This method assumes that inventory that entity bought first will be the first to be issued. In other words inventory units are withdrawn from the oldest inventory held by the entity for the sales or consumption.

This implies that fact that inventory at the end of the period held by the entity is the newest one.

Example FIFO method

An entity has 100 units in store that were purchased over a period of time with following details:

July 1 – 30 units with price per unit 10 = $300
July 7 – 40 units with price per unit 12 = $480
July 9 – 30 units with price per unit 11 = $330

If entity has issued 40 units to production hall  on July 12 then valuation will be done as follows:

Value of inventory issued:

30 units @ $10=300
10 units @ $12=120
40 units420

Value of inventory at hand:

30 units @ $12=360
30 units @ $11=300
60 units660

2 Last in First Out (LIFO) Method

This method assumes that units that entity bought latest will be issued first. In other words inventory units are withdrawn from the latest inventory held by the entity for the sales or consumption.

This also implies that inventory at the end of the period still in the store is the oldest one.

Example LIFO method

An entity has 100 units in store that were purchased over a period of time with following details:

July 1 – 30 units with price per unit 10 = $300
July 7 – 40 units with price per unit 12 = $480
July 9 – 30 units with price per unit 11 = $330

If entity has issued 40 units to production hall  on July 12 then valuation will be done as follows:

Value of inventory issued:

30 units @ $11=330
10 units @ $12=120
40 units450

Value of inventory at hand:

30 units @ $10=360
30 units @ $11=330
60 units690

3 Average Value of Cost (AVCO) Method

In this method the costs are averaged out and for computation of inventory consumed/sold and inventory still in the store is measured on the basis of average cost figure.

Example AVCO method

An entity has 100 units in store that were purchased over a period of time with following details:

July 1 – 30 units with price per unit 10 = $300
July 7 – 40 units with price per unit 12 = $480
July 9 – 30 units with price per unit 11 = $330

If entity has issued 40 units to production hall  on July 12 then valuation will be done as follows:

Average cost of purchase is calculated by dividing the total cost of goods available for sale over total units available for sale:

(300 + 480 + 330) / (30 + 40 + 30) => 1,110 / 100 = 11.1

Value of inventory issued: 40 x 11.1 = 444
Value of inventory at hand: 60 x 11.1 = 666

4 Specific Identification method

In order to use any of the above discussed methods, it is necessary that nature and use of units is same and are interchangeable. For example set of dining chairs produced in large quantities will be similar and thus any unit can be used or sold interchangeably.

However, if units are not ordinarily interchangeable or they differ in nature or use then we use specific identification method in which costing of each unit is done separately as each unit is different from another. For example a dining table designed as per customer’s request that has a different color, finish and size. Thus cost of this unit needs to be measured separately from the units that are available for general public.

Another example can be dress designer that stitch two types of clothing:

  1. fixed size shirts for its retail customers; and
  2. custom fit shits that are designed for specific customer

For the retail shirts entity may use either of FIFO, LIFO or AVCO but for custom fit shirts valuation will be done using specific identification method.

Though the above explanations and examples simplify how each method differ from the each other, the manner in which changes in inventory are recorded however depends if entity is using perpetual inventory system or periodic inventory system