Chapter 11 – Inventory Cost Flow
Cost Formulas
PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using either:
o First in, Four out (FIFO)
o 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 (FIFO)
This 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
FIFO is in accordance with the ordinary merchandising procedures 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 is representative
of earlier or old prices
This method favors the statement of financial position in that the inventory is stated at current
replacement cost
The objection to this 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 inflation or rising prices, the FIFO method would result to the highest net
income. However, in a period of deflation or declining prices, the FIFO method would result to be the
lowest net income.
Illustration – FIFO page 331-332
Weighted average – Periodic
The cost of the beginning inventory plus the total cost of purchase 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 for the period
Units Unit cost Total Cost
Jan 1 Beg balance 800 200 160,000
18 Purchase 700 210 147,000
31 Purchase 500 220 110,000
Total goods
available for sale 2,000 417,000
Weighted average unit cost (417,000 / 2,000) 208.50
Inventory cost (700 x 208.50) 145,950
Cost of goods sold
Inventory – Jan 1 160,000
Purchases 257,000
Goods available for sale 417,000
Inventory – Jan 31 (146,950)
Cost of goods sold 271,000
Weighted average - Perpetual
When used in conjunction with the perpetual system, the weighted average method is popularly known
as 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 purchase
Units Unit cost Total cost
Jan 1 Balance 800 200 160,000
8 Sale (500) 200 (100,000)
Balance 300 200 60,000
18 Purchase 700 210 147,000
Total 1,000 207 207,000
22 Sale (800) 207 (165,600)
Balance 200 207 41,400
31 Purchase 500 220 110,000
Total 700 216 151,400
Observe that a new weighted average unit cost is computed after every purchase
Thus, after the January 18 purchase, the total cost of P207,000 is divided by 1,000 units to get a weighted
average unit cost of P207
After the January 31 purchase, the total cost of 151,400 is divided by 700 units to get a new weighted
average unit cost of P216
Cost of goods sold from the stock card
Jan 8 sale 100,000
22 sale 165,000
Cost of goods sold 265,600
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 rapid 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)
This 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 expressed in terms of earlier or old prices and the cost of goods sold is representative
of recent or new prices
This method 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 this method is that the inventory is stated at earlier 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, such as by making year-end purchases designed
to preserve existing inventory layers. At times, these purchases may not even be in the best economic
interest of the entity
In the period of rising prices, the LIFO method would result to the lowest net income. In the period of
declining prices, the LIFO method result to the highest net income
Illustration – pages 335 – 337
Specific identification
Means that specific costs are attributed to identified items of inventory
The cost of 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
This 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 and on hand
The major argument against this method is thatat it is very costly to implement with high-speed
computers.
Standard costs
Predetermined product cost established on the basis of normal levels of materials and supplies, labor,
efficiency and capacity utilization
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 accost 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
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. Assume that the said
products have the following sales price: A P5,000,000, B P1,500,000, and C P3,000,000
Computation of cost of each product
Product A 500,000 5/50 x 3,000,000 300,000
Product B 1,500,000 15/50 x 3,000,000 900,000
Product C 3,000,000 30/50 x 3,000,000 1,800,000
5,000.000 3,000,000
