Skip to main content

10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions

Cost Flow Assumptions​

When inventory items are purchased at different costs, a business must decide which costs to assign to goods sold and which costs remain in inventory. This is called a cost flow assumption.

Key Concept: The cost flow assumption doesn't necessarily match the physical flow of goods. It's an accounting method for assigning costs.

Inventory Valuation Methods​

There are three main inventory valuation methods:

  1. FIFO (First-In, First-Out)
  2. Weighted Average
  3. Specific Identification

FIFO (First-In, First-Out)​

Assumption: The first items purchased are the first items sold.

How it Works:

  • Oldest inventory costs are assigned to cost of goods sold
  • Newest inventory costs remain in ending inventory
  • Matches physical flow for perishable goods (food, etc.)

Example:

  • January 1: Purchase 100 units @ €10 = €1,000
  • January 15: Purchase 100 units @ €12 = €1,200
  • January 20: Sell 120 units

FIFO Cost Assignment:

  • Cost of Goods Sold: 100 units @ €10 + 20 units @ €12 = €1,000 + €240 = €1,240
  • Ending Inventory: 80 units @ €12 = €960

Characteristics:

  • Ending inventory reflects most recent costs
  • Cost of goods sold reflects older costs
  • In periods of rising prices: Higher ending inventory, lower cost of goods sold, higher net income

Weighted Average​

Assumption: All units have the same average cost.

How it Works:

  • Calculate average cost per unit: Total Cost ÷ Total Units
  • Apply average cost to both cost of goods sold and ending inventory

Example:

  • January 1: Purchase 100 units @ €10 = €1,000
  • January 15: Purchase 100 units @ €12 = €1,200
  • Total: 200 units @ €11 average = €2,200
  • January 20: Sell 120 units

Weighted Average Cost Assignment:

  • Average Cost: €2,200 ÷ 200 = €11 per unit
  • Cost of Goods Sold: 120 units @ €11 = €1,320
  • Ending Inventory: 80 units @ €11 = €880

Characteristics:

  • Smooths out cost fluctuations
  • Ending inventory and cost of goods sold use same average cost
  • Moderate effect on income during price changes

Specific Identification​

Assumption: Each item is tracked individually, and its specific cost is used.

How it Works:

  • Each item has a unique identifier
  • Track cost of each specific item
  • When sold, use that item's specific cost

Example:

  • Purchase Item A: €100
  • Purchase Item B: €120
  • Purchase Item C: €110
  • Sell Item B

Specific Identification Cost Assignment:

  • Cost of Goods Sold: €120 (Item B's specific cost)
  • Ending Inventory: €100 + €110 = €210 (Items A and C)

Characteristics:

  • Most accurate method
  • Only practical for unique, high-value items
  • Used for cars, jewelry, art, etc.
  • Not practical for most inventory

Comparison of Methods​

Example with Same Data:

Purchases:

  • Jan 1: 100 units @ €10 = €1,000
  • Jan 15: 100 units @ €12 = €1,200
  • Jan 30: 100 units @ €14 = €1,400
  • Total: 300 units @ €12 average = €3,600

Sales:

  • Sold 200 units during January

FIFO:

  • COGS: 100 @ €10 + 100 @ €12 = €2,200
  • Ending: 100 @ €14 = €1,400

Weighted Average:

  • Average: €3,600 ÷ 300 = €12
  • COGS: 200 @ €12 = €2,400
  • Ending: 100 @ €12 = €1,200

Specific Identification:

  • Depends on which specific items were sold

Impact of Price Changes​

Rising Prices (Inflation):

  • FIFO: Lower COGS, higher ending inventory, higher net income
  • Weighted Average: Moderate COGS and ending inventory
  • LIFO (not allowed in Luxembourg): Higher COGS, lower ending inventory, lower net income

Falling Prices (Deflation):

  • FIFO: Higher COGS, lower ending inventory, lower net income
  • Weighted Average: Moderate COGS and ending inventory

Luxembourg Requirements​

Allowed Methods:

  • FIFO
  • Weighted Average
  • Specific Identification (for appropriate items)

Not Allowed:

  • LIFO (Last-In, First-Out) - not allowed in Luxembourg

Requirements:

  • Must use consistent method
  • Must be disclosed in financial statements
  • Must be reasonable and supportable
  • Must comply with PCN requirements

Luxembourg Compliance Note​

In Luxembourg:

  • FIFO and weighted average are most common
  • Must use consistent method (can't change without justification)
  • Must be disclosed in notes to financial statements
  • Must support inventory values with documentation
  • Must comply with PCN Class 3 requirements

Think It Through​

Why might a business choose FIFO over weighted average? What are the advantages and disadvantages of each method?