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Inventories

Stock inventories take on different forms. In businesses that are engaged in manufacturing, there may be raw materials to be used for production, or the finished goods still on hand available for sale while some others include the goods still in the process of production. In merchandising companies, there is merchandise held for resale. Emphasis is given on the significance of inventory procedures as well as inventory costing methods as critical in the computation of the business’s Cost of Goods Sold, its related Gross Profit and the final Net Income. The consistency, by which the inventory costing methods is applied, is specifically required by GAAP. In addition, GAAP rules require that the costing method used should be indicated in the financial reports.

There are different inventory costing methods, namely FIFO, LIFO and Average Costs and each method will have different effects. Regardless of the choice of costing method to use, the accounting principles of consistency and accuracy should always prevail. In order to adhere to and maintain these two accounting principles, management should establish a clear-cut policy as to which should be applied.

In as much as the prices of goods bought for resale or raw materials for production may vary within a single accounting cycle, the matter of understanding the basic concepts of each costing method should be one’s first concern.

FIFO or First-in, First-Out Method

In this type of inventory costing method, the valuation of the ending inventory is based on the prices per unit of the most recent purchases up to the quantity that each price represents in the purchases account. Going back to the Cost of Goods Sold formula, the beginning inventory plus the total purchases is captioned as Total Goods Available for Sale for the Year. After the ending inventory is deducted, the resulting difference is captioned as Cost of Goods Sold. Hence, it is presumed that whatever amount of inventory left unsold or unused, carries the cost of the most recent purchases that were added to the inventory.

LIFO or Last-in First-out Method

This inventory costing method is the exact opposite of FIFO, wherein the remaining inventory at year end will be valued at the unit cost based on the earliest purchase prices, which may include the cost of the goods based on previous year’s price records. However, to compute the value of the inventory at year end, there must be a careful monitoring of the prices and quantity of every stock inventory movement from the beginning balance to the purchases and up to the ending inventory.

Average Cost Method

This method makes use of the mathematical concept of averaging the total value over the total number of units to arrive at the average cost per unit.

    Based on the above-comparison, it can be noted that the LIFO method results to a higher amount of COGS when prices are rising, if compared to the COGS produced by the two others, FIFO and Average Costs. Higher costs equates to lower income and management will have to decide which of these three different inventory costing method will be applied on a consistent basis for the whole accounting cycle.

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