INVENTORY COSTING METHOD

When the inventory items are few and are not ordinarily interchangeable.

specification identification technique may be used. Specific

identification of cost means that specific costs are attributed to identify

items of inventory.

When there are large numbers of items of inventory that are usually

interchangeable, perpetual inventory system is usually used. Under the

system, unit costs and total costs should be computed each time materials

are received or issued. The primary basis of inventory valuation is cost.

Since unit prices vary from one purchase to another, an assumption should

be made about the flow of costs. There are three methods to determine

the cost of ending inventory to be reported. These methods are as follows:

*First in, first out (FIFO) method.

Under this method, the first

materials purchased (the oldest or earliest) are the first materials

to be used. The materials on hand are therefore assumed to be

the last one purchased.

*Last in, first out (LIFO) method.

Under this method, the last

materials purchased the most recent) are the first materials to

one purchased

be used. Then the materials on hand are assumed to be the first one purchased.
*The moving average method.

In this method all the costs are

commingled and an average cost is computed with each new

purchase and assigned to materials issued and on hand.

Illustration

To illustrate the application of these methods, assume the following

transactions relating to Material IJ-4, inkjet:

May 1: The beginning balance on hand is 150 units, costing P150 each.

6: 150 units are purchased under Purchase Order 08 at P155

each.

10: 180 units are issued for use per Requisition 10.

21: 150 units are purchased on Purchase Order 9 for P156.

23: 160 units are issued for use on Requisition 16.

25: 10 units are returned to the storeroom as noted on Returned

Materials Report 3. These units has been issued on May 10

for use on Requisition 10.

First In, First Out Method

The materials ledger card shows the transactions relating to Material

A-l are recorded under the FIFO method.

ILLUSTRATION 4-1
The following should be noted in the Materials Ledger Card above:

*The price for each issue is individually computed

*These of 180 units on May 10 includes all the 150 units from

the beginning inventory (150 units at P150 each) plus 30 of the

units purchased on May 6 630 units at P155 each)

*The base of 160 units on May 23 includes the remaining 120

units from the May 6 purchases (120 units at P155 each) plus 40

wits purchased on May 21 (40 units at P156 esch).

*The 10 excess units returned to the storeroom on May 25 are

priced at P155 because they relate to the issue of May 10 and

resumed to be part of the group of 30 units. The job finally

will be charged only with the costs that would have been charged

if the correct quantity has been issued on May 10 (150 units at

P150 each + 20 units at P155 each).

*Of the 130 units on and on May 15, all except 10 units returned

are priced at the most recent cost, P156 per unit.

Chapter

Arguments in favor of the first in first out method are that it 18 easier

and less costly to use because FIFO requires less recordkeep

LIFO; that it reflects the actual p

that it reflects the actual physical flow of goods; and that the

inventory shown in the balance sheet is more relevant because

e balance sheet is more relevant because it includes

the most recent costs and is an estimation of replacement cost.

On the other hand, a strong argument aga

ther hand, a strong argument against the first in, first out method

S that it does not match current costs against current sales revenue,

because under this method the ending inventory is priced at the most

recent costs, resulting the cost of goods sold to be priced at the oldest

costs. Therefore, when the net income is computed, the cost of goods sold

that is deducted from sales revenue does not include the most recent

costs. This can lead to distortions of net income in period of rising prices

since the costs of goods sold is understated.

Last In, First Out Method

Using the same transactions for Material IJ-4, the Materials Ledger Card

under the LIFO method is shown below:

ILLUSTRATION 4-2

The following should be noted in the Materials Ledger Card (Illustration

4-2) under the LIFO Method:

*The issue of 180 units on May 10 consists of the 150 units purchased on May 6 (150 units at P155 each)
plus 30 units from

the beginning inventory (30 units at P150 each). Note that the issues are recorded in reverse order. That
is, the 30 units at P150 each is shown first followed by 150 units at P155 each. The sequence enables you
to compare the FIFO and LIFO methods

more easily.
*On May 23 the issue of 160 units consists of the 150 units purchased on May 21 (150 units at P156
each) plus 10 units from

the beginning inventory (10 units at P150 each).

*The 10 excess units returned to the storeroom on May 25 relate to the issue of May 10 and are
assumed to be part of the 30 units (the oldest). Thus the job finally will be charged only with the costs
that would have been charged if the correct quantity had been issued (150 units at P155 each + 20 units
at P150 each).

•All the 120 units on hand on May 25 (10 + 110) are priced at the earliest cost, P150 per unit. Note that
these units would normally be recorded together as 120 units at P150 each. They are

recorded separately here to facilitate the comparison of FIFO and LIFO methods.

The major argument in favor of the last in, first out method is that current

cost are matched against current revenue, because the cost of goods sold contains the most recent
costs. Therefore, the net income figure is a better measure of the current earnings.

Some critics oppose the use of the LIFO method because it usually

represents an unrealistic physical flow of goods. However, as stated earlier

the physical flow of goods does not have to correspond to the inventory

costing method used.

Moving Average Method

Neither the FIFO nor the LIFO method is entirely satisfactory in valuing

inventories. Therefore, the moving average method may be used as a

compromise. Under this method, the units and cost of each new purchase

are added to the balances already on hand when the purchase is received,

and a new average cost per unit is computed. When materials are issued,

they are charged out at this average cost until another purchase is received

or a return is recorded, when a new average cost per unit is computed.

Materials Ledger Card under the Moving Average Method different values from FIFO and LIFO methods
are shown on the next

page.

ILLUSTRATION 4-3

The following should be noted in the Materials Ledger Card above:

*The 180 units issued on May 10 are priced at P152.50 per unit (the unit price appearing in the Balance
section on the line above).

*The 160 units issued on May 23 are priced at P154.44 per units (P16,988.40 divided by 270 units).

*The 10 excess units returned to the storeroom on May 25 are priced at P152.50 the price on May 10.

*The 120 units remaining in stock on May 25 valued at P154.27, the current average price

One advantage of the moving average method is that it is relatively simple 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 at the weighted average method is that there may be

considerable lag between the current cost and inventory valuation since

the average unit cost involves early purchases.

Philippine Accounting Standard (PAS) No. 2 (Inventories) prescribes the

use of the FIFO and the Moving Average Methods to compute the cost of

inventories LIFO is no longer permitted under PAS 2.

• Valuation at Cost or Net Realizable Value, Whichever is Lower

PAS No. 2 provides that inventories shall be measured at the lower of

cost and net realizable value. Net realizable value (NRV) refers to the

estimated selling price in the ordinary course of business less the

estimated cost of completion and the estimated cost necessary to make

the sale. When the net realizable value has declined below the original

cost, inventory should be valued at net realizable value instead of cost

The rule of cost or net realizable value, whichever is lower may be applied

as follows:

• Lower of Cost or Net Realizable Value by Item

Under this plan, the cost and the net realizable value of each item in

inventory are determined. After which, the basis of valuation (the lower

figure) is identified for each item and is multiplied by the quantity on

hand to obtain the value of the lower of cost or NRV. The lower valuation

figure for cach item is used to compute the value of the inventory is

whole as shown below:

• Lower of Total Cost or Total NRV

Another method of valuation is to calculate the total cost and the total

NRV of the entire inventory. The lower of this total is then used as the

inventory valuation, as illustrated below:

If the prices of some materials increased and others decreased the above method gives a less
conservative valuation than the by-item methods.