Inventory and cost of goods sold

In depth

What goes into the cost of inventory

Inventory is recorded at cost, applying the historical cost principle. Cost includes everything spent to bring the goods to their present location and condition: the purchase price, import duties and taxes the business can’t recover, and transport, handling and other costs directly attributable to buying them; trade discounts, rebates and similar items are deducted (IAS 2 paragraphs 10 and 11). So freight-in, the cost of shipping goods to the buyer, is part of inventory. A discount for paying a supplier early reduces the cost too: a buyer that pays within the discount period credits Inventory for the discount taken.

Costs of selling are not inventory (IAS 2 paragraph 16). Shipping goods out to customers (freight-out) is never added to inventory; it is an expense of the period in which the goods are shipped. Where it appears is a presentation policy: introductory texts treat it as a selling (delivery) expense and Lantern does the same, so its $12,630 of couriers and postage sits among operating expenses, while some companies include outbound shipping in cost of sales. Kilnworth’s prices include delivery to Lantern’s kitchen, so freight-in is already inside the $58,600.

Perpetual and periodic systems

A perpetual inventory system updates Inventory with every purchase and every sale. When a bag ships, two entries are made at once: revenue and a receivable or cash, as in the last lesson, and the cost of the bag moved from Inventory to Cost of Goods Sold. Lantern’s shop software does this, so the year’s summary entries record purchases of $58,600 and cost of goods sold of $52,400 from the perpetual records.

A return reverses both entries. When a customer sends back goods that can be sold again, the refund goes through Sales Returns and Allowances, as in the last lesson, and the goods go back into Inventory at their cost, with a credit to Cost of Goods Sold. If the goods are damaged and thrown away, as Lantern’s were, only the refund is recorded: there is nothing to put back on the shelf.

A periodic inventory system records purchases in a Purchases account during the period and leaves Inventory untouched until the period end. A physical count then gives ending inventory, and cost of goods sold is calculated with the formula above. Periodic records are cheaper to keep but say nothing about cost of goods sold until the count, and they can’t separate goods sold from goods stolen, spoiled or lost.

Even a perpetual system needs a count. Records drift from reality through shrinkage (goods lost to theft, damage or error), and only a count finds goods that are on hand but worth less than they cost. When the count is lower than the records, the difference is moved from Inventory to Cost of Goods Sold. Lantern’s count agreed with its records in quantity, but found the unsold Holiday Blend; that adjustment comes later in the lesson.

Cost formulas: FIFO, LIFO and weighted average

When identical items are bought at different costs, the business needs a rule for which cost goes with the items sold. Items that are not ordinarily interchangeable, such as cars or works of art, are costed by specific identification: each item carries its own cost. For interchangeable items, such as bags of the same coffee, accounting uses a cost formula. The formula is an assumption about the flow of costs, not a description of which bags physically leave the shelf.

• FIFO (first in, first out): the oldest costs go to cost of goods sold first; ending inventory carries the most recent costs.
• LIFO (last in, first out): the newest costs go to cost of goods sold first; ending inventory carries the oldest costs.
• Weighted average cost: every unit carries the average cost of the goods available, total cost divided by total units.

Lantern’s House Blend in the fourth quarter shows how far the three can diverge. Kilnworth raised its price with each delivery, from $8.00 a bag in the opening stock to $9.00 in December. Lantern shipped 2,600 of the 3,000 bags available, leaving 400 on 31 December.

• FIFO. The 2,600 bags sold take the oldest layers first: $2{,}400 + 5{,}040 + 7{,}920 + 800 \times 9.00 = 22{,}560$. The 400 bags left carry December’s cost: $400 \times 9.00 = 3{,}600$.
• LIFO (periodic). The bags sold take the newest layers first: $10{,}800 + 7{,}920 + 500 \times 8.40 = 22{,}920$. The 400 bags left carry the oldest costs: $2{,}400 + 100 \times 8.40 = 3{,}240$.
• Weighted average (periodic). Average cost $26{,}160 \div 3{,}000 = 8.72$ a bag; cost of goods sold $2{,}600 \times 8.72 = 22{,}672$; ending inventory $400 \times 8.72 = 3{,}488$.

Each pair adds back to $26,160: the formula only divides the pool. Under a perpetual system FIFO gives the same answer whenever the costs are assigned, because the oldest bags on hand are always the oldest. LIFO and the average do not: applied sale by sale, perpetual LIFO takes the newest cost at the date of each sale, and the moving average recalculates the average after every purchase. The challenging example works one case every way. Lantern’s own records are perpetual FIFO, which is why its year-end House Blend is the December layer, $3,600.

What the choice does when costs rise

When purchase costs rise, FIFO gives the lowest cost of goods sold, the highest gross profit and the highest ending inventory; LIFO gives the opposite; the average sits between. Each has a claim to be more accurate. LIFO matches recent costs with current revenue, so its gross profit is closer to what the business earns on replacing what it sells. FIFO leaves recent costs on the balance sheet, so its inventory is closer to what the goods would cost today. When costs fall the rankings reverse, and when costs are flat the formulas agree.

The only cash difference is tax. Selling the same bags at the same prices, Lantern pays the same suppliers and receives the same cash under every formula, but LIFO’s lower taxable profit would cut the quarter’s tax by $0.25 \times 360 = 90$ dollars at the course’s assumed 25% rate. Over many years of rising prices the saving builds up, which is LIFO’s main attraction for US companies whose costs keep rising.

The lower of cost and net realisable value

Inventory is never carried at more than the business expects to recover from it. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the costs of making the sale. Cost may not be recoverable when goods are damaged or obsolete, when selling prices have fallen, or when the costs to complete or sell them have risen (IAS 2 paragraphs 9 and 28). Inventory is then written down to net realisable value, and the inventory write-down is an expense of the period in which it happens (paragraph 34).

US GAAP reached the same test in 2015. ASU 2015-11, issued in July 2015 and effective for fiscal years beginning after 15 December 2016, requires inventory measured by any method other than LIFO or the retail inventory method (which estimates the cost of inventory from its selling prices, using the ratio of cost to retail price) to be measured at the lower of cost and net realisable value (ASC 330-10-35-1B). Inventory measured by LIFO or the retail inventory method keeps the older lower of cost or market test (ASC 330-10-35-1C), in which “market” is based on current replacement cost. Older textbooks describe lower of cost or market for all inventory; for a FIFO business like Lantern that is no longer the rule.

Lantern’s count found 125 bags of Holiday Blend, a seasonal coffee in festive packaging, that cost $1,000. After Christmas they can be sold only at a clearance price, which after card fees and shipping leaves $600. The write-down of $400 is charged to Cost of Goods Sold, a common presentation, so the year’s cost of goods sold becomes $52{,}400 + 400 = 52{,}800$.

What if net realisable value recovers while the goods are still held? Suppose that in February 2027 a café chain offers to take the Holiday Blend for a price that leaves $800 after costs. Under IFRS the business reassesses net realisable value each period and reverses the write-down when it recovers, but only up to the original write-down, so that the carrying amount is the lower of cost and the revised net realisable value; the reversal reduces the inventory expense of the period (IAS 2 paragraphs 33 and 34). Under US GAAP a write-down at the close of a fiscal year makes the reduced amount the cost for later accounting (ASC 330-10-35-14), so it isn’t written back up; the recovery shows as a higher profit when the goods are sold. (Within one fiscal year, a write-down made in an interim period may be recovered in a later interim period of the same year.)

Inventory errors

Because cost of goods sold is calculated from ending inventory, a mistake in the count flows straight into profit. If ending inventory is overstated by $2,000, cost of goods sold is understated and gross profit overstated by $2,000. The error doesn’t stop there: this year’s ending inventory is next year’s beginning inventory, so next year’s cost of goods sold is overstated and its gross profit understated by the same $2,000.

After income tax at Lantern’s assumed 25%, each year’s net income is misstated by $2{,}000 \times (1 - 0.25) = 1{,}500$, with the rest of the error in income tax. The error is called self-correcting because retained earnings are right again at the end of year 2. That is cold comfort: both years’ profits were wrong, any bonus or tax based on them was wrong, and a reader comparing the two years saw a swing of $4,000 in gross profit that never happened.