Merchandise inventory cost
The merchandise inventory is for some companies the most important part of their business and sometimes the most complex. Inventory as you should know is an asset. Inventory account records the merchandise (goods or services) inputs or outputs (amount in price per units). From inventories we got sales revenues and cost of goods sold. Sales revenues are recorded as revenues and cost of goods sold is part of the inventory, these are units of inventory sold multiplied by cost per unit of inventory. Beginning balance of the inventory must be taken into account when we calculate the amount of goods ready to be sold, means the amount of goods available for sale are the purchases of inventory plus the beginning balance of the inventory. Then cost of goods sold is subtracted from the total amount of goods sold, now we have the ending inventory balance. To match the cost of goods sold we have on hand a few methods
- Weighted average: is the basic way to match cost of goods sold. Divide cost of goods available for sale (cost of goods multiplied by number of units available) by the total units available for sale and you´ve got the average price to allocate cost of goods sold. Now, multiply this average price by the units sold and you got cost of goods sold.
- FIFO: fist in, first out. The first cost of goods is the first to cost of goods sold. Here, instead of having a weighted average price we use the first cost of goods as the price, then the second so forth. For example, if there´ve been 15 units of inventory sales and the first and second cost of goods you have are 100 (10 units@$10) and 150 (10 units @$15) you´ll have as cost of goods sold 175 (10 units @$10 + 5 units@$15).
- LIFO: last in, first out. This method is the inverse of FIFO. The last cost of goods incurred is the first to cost of goods sold. Hence, if you there´ve been 15 units of inventory sales and the first and second cost of goods you have are (10 units@$10) and 150 (10 units @$15) you´ll have as cost of goods sold 175 (10 units @$15 + 5 units@$10).
Apparently, there was a coincidence that we had the same amount in FIFO as in LIFO, but generally we have a wider range of units and prices, so it does vary much more depending on the method you used.
What make these three methods distinctive each other is their objectives and the way they´re used. As long as prices are increasing, FIFO method reflects more profit, but less gross profit (sales revenues – cost of goods sold) as well as LIFO method shows higher cost of goods sold, which usually means less taxes. Weighted average method is almost between FIFO and LIFO but during inflation, weighted average has very high cost of goods sold (so it does nothing against the inflation effect). FIFO even can be manipulated to show more income in a firm, it is also very suitable for cost declining industries, it matches well. For the rest, LIFO does matches better, due to the fact that it keeps walking with current time price changes, a consequence of this, is a decrease on replacement costs.