Example Exercise 1 Inventory Cost Flow Assumptions When identical units of merchandise are acquired at different unit costs, it is necessary to determine the cost of the units when they are sold using a cost flow assumption. Three common cost flow assumptions and related inventory cost flow methods include first-in first-out, or FIFO (pronounced fie-foe), last-in first-out, or LIFO (pronounced lie-foe) and average cost.

Example Exercise 1 Inventory Cost Flow Assumptions - FIFO To illustrate the FIFO method, consider the three purchases shown. One unit was sold leaving two units in ending inventory. Under the FIFO method, first-in first-out, the first unit purchased is considered to be sold, thus arriving at cost of merchandise sold of $9. Using FIFO leaves the ending inventory of two units made up of the May 19th and the May 24th purchases or $27, calculated as $13 plus $14.

Example Exercise 1 Inventory Cost Flow Assumptions - LIFO In contrast, under the LIFO method, the cost of merchandise sold is the last unit purchased, last-in first-out, even though it does not match the physical flow of goods. Therefore, the cost of merchandise sold is $14, the cost of the last unit purchased. The merchandise inventory is comprised of the first two purchases, May 10th for $9 and the May 19th for $13, for a total of $22 calculated.

Example Exercise 1 Inventory Cost Flow Assumptions–Average Cost The average cost method uses an average of the cost of the units purchased during the period. The average cost is calculated as the total purchases of $9 + $13 + $14, or $36, divided by three; the number of units of purchased to get an average cost of $12. Since one unit was sold during the period, the cost of merchandise sold is $12. The merchandise inventory is calculated as $12 times 2 units in ending inventory, or $24.

2 Example Exercise 1 (a) FIFO Sales $70 Now let’s look at the example exercise. First, we must determine the cost of the inventory using the FIFO method [CLICK]. Under the FIFO method, the first item purchased is the first one sold [CLICK]. Since one unit is sold, the cost of merchandise sold would be the first unit purchased of $45. The gross profit is calculated [CLICK] as the sales price per unit of $70 less the cost of merchandise of sold of 45 to arrive at gross profit of $25. Next, we must determine the cost of the ending inventory. There are 2 units left in ending inventory, [CLICK] the last two units purchased of $48 + $51, or $99. (a) FIFO Sales $70 Less cost of merchandise sold (45) Gross Profit $25 Ending Inventory ($48 + $51) $99

2 Example Exercise 1 (b) LIFO Sales $70 Next, we must determine the cost of the inventory using the LIFO method [CLICK]. Under the LIFO method, the last item purchased is the first one sold. Since one unit is sold, the cost of merchandise sold would be the last unit purchased for $51. The gross profit is calculated [CLICK] as the sales price per unit of $70 less the cost of merchandise sold of $51 to arrive at gross profit of $19. Next, we must determine the cost of the ending inventory. There are 2 units left in ending inventory, [CLICK] the first 2 units purchased of $45 + $48, or $93. (b) LIFO Sales $70 Less: cost of merchandise sold (51) Gross Profit $19 Ending Inventory ($45 + $48) $93

2 Example Exercise 1 (c) Average Cost Sales $70 Finally, we must determine the cost of the inventory using the average cost method. Under the average cost method, an average cost per unit must be calculated [CLICK]. The total cost of the items purchased is divided by the number of items purchased provides the average cost per unit. In this case the average cost is $48 per unit. Since one unit is sold, the cost of merchandise sold is $48. The gross profit is calculated [CLICK] as the sales price per unit of $70 less the cost of merchandise of $48 sold to arrive at gross profit of $22. Next, we must determine the cost of the ending inventory [CLICK]. There are 2 units left in ending inventory, these 2 units are multiplied by the average cost per unit to arrive at ending inventory of $96. (c) Average Cost Sales $70 Less: cost of merchandise sold (48) Gross Profit $22 Ending Inventory ($48 x 2) $96

Example Exercise 1 1  For Practice: PE 1A, PE 1B 1 Refer to Practice Exercises PE 1A and PE 1B to practice on cost flow methods. 1  For Practice: PE 1A, PE 1B