| Current inventory levels affect the balance sheet of | | | | 350,000 X $0.75, 250,000 X $1.00). The average |
| a company. The amount of product multiplied by | | | | price paid per lollipop is $0.62 ($712,500 divided by |
| the cost determines the amount of inventory | | | | 1,150,000). If Candy Inc. sold 1 million lollipops in 2008 |
| reflected on the balance sheet. Inventory valuation | | | | 150,000 lollipops remained at the end of the year. |
| is easy for companies selling small quantities of high | | | | The remaining inventory would be valued at |
| value products because the number of items in | | | | $92,934.78 (150,000 X $0.62) and the cost of goods |
| inventory at any given time is small. Larger retailers | | | | sold throughout the year would be $619,565.20 |
| like Wal-Mart and Costco have greater difficulty | | | | (1,000,000 X $0.62). If Candy Inc. sold each lollipop |
| assigning inventory values and costs of goods sold | | | | at $1.25 the net income for 2008 would be |
| because of the large number of products that flow in | | | | $630,434.80 ($1,250,000 - $619,565.20). |
| and out. To make this process easier there are | | | | The First-in, first out (FIFO) method is slightly more |
| multiple methods of assigning value to inventory. | | | | complicated than the weighted average. Despite the |
| We will detail these methods through a fictional | | | | way inventory flows in and out of a company the |
| company, Candy Inc., to better understand how each | | | | value assigned to the cost of goods sold and current |
| affects inventory value and cost of goods sold at | | | | inventory would be based on first products in would |
| the end of the fiscal year. | | | | be the cost assigned to first products out the door. |
| Candy Inc. sells on average four million lollipops per | | | | In the Candy Inc. example, 1.15MM lollipops were |
| year. They purchase their inventory every quarter | | | | purchase throughout the year at varying prices and |
| based on the previous quarter’s sales. In 2008 | | | | 1MM were sold. The cost of goods sold for the |
| Candy Inc. purchased 300,000 lollipops on January 1, | | | | year is $562,500 (300,000 X $0.25, 250,000 X $0.50, |
| 250,000 lollipops on April 1, 350,000 on July 1 to | | | | 350,000 X $0.75, 150,000 X $1.00). The remaining |
| account for summer demand and 250,000 on | | | | inventory is $150,000 (150,000 X $1.00). If Candy |
| October 1 to account for the remainder of the | | | | Inc. sold each lollipop at $1.25 the net income under |
| year. In 2008 the candy industry experienced its | | | | the FIFO cost assumption would be $687,500.00 |
| highest levels of inflation, rising costs, in 50 years. | | | | ($1,250,000 - $562,500). |
| Each quarter saw a 25 cent increase because of the | | | | Last-in, first out (LIFO) is the opposite of FIFO. The |
| rising costs of sugar. As product flowed in and out | | | | inventory values assigned to the cost of goods sold |
| of Candy Inc. it became impossible to assign actual | | | | and the current inventory are based on the last |
| value to the cost of goods sold and the current | | | | items purchased are assigned to the cost of goods |
| inventory. This example will help us understand the | | | | sold. The remaining inventory is then based on the |
| four inventory cost flow assumptions and how they | | | | cost of those products purchased earlier in the |
| affect current assets and net income. | | | | year. In the Candy Inc. example, 1.15MM lollipops |
| The four inventory cost flow assumptions are | | | | were purchase throughout the year at varying prices |
| specific identification, weighted average, FIFO (first-in, | | | | and 1MM were sold. The cost of goods sold for the |
| first-out) and LIFO (last-in, first-out). Specific | | | | year is $675,000 (150,000 X $0.25, 250,000 X $0.50, |
| identification is assigning value of the cost of goods | | | | 350,000 X $0.75, 250,000 X $1.00). The remaining |
| sold and the current inventory based on the actual | | | | inventory is $37,500 (150,000 X $0.25). If Candy Inc. |
| price paid. For Candy Inc. the cost of each lollipop | | | | sold each lollipop at $1.25 the net income under the |
| from the manufacturer would be assigned to each | | | | LIFO cost assumption would be $575,000.00 |
| lollipop. The problem Candy Inc would experience | | | | ($1,250,000 - $675,000). |
| given the volume of candy sold is mixed up | | | | As you can see each of the different inventory cost |
| inventories which would make it virtually impossible to | | | | flow assumptions greatly impacts the net income and |
| know the true cost of a single lollipop when it was | | | | current inventory values. In our example, Candy |
| sold to a consumer. | | | | Inc’s net income was $630,434.80 under the |
| Another cost option is the weighted average cost | | | | weighted average method, $687,500.00 under FIFO |
| flow assumption. Under this assumption the average | | | | and $575,000.0 under LIFO. The current inventory |
| price paid for the lollipops would be determined and | | | | that makes up part of current assets was |
| assigned to remaining inventory and cost of goods | | | | $92,934.78 under the weighted average method, |
| sold. In our example, each quarter saw a 25 cent | | | | $150,000 under FIFO and $37,500.0 under LIFO. |
| increase. In January lollipops cost 25 cents, in April | | | | Manipulation of current assets and net income would |
| they cost 50 cents, in July they cost 75 cents and in | | | | be easy if companies used different methods |
| October they cost 1 dollar. In the weighted average | | | | depending on the economic climate, therefore it is |
| model the total cost of inventory purchased for 2008 | | | | important to be consistent so users of financial |
| is $712,500.00 (300,000 X $0.25, 250,000 X $0.50, | | | | accounting may accurately assess trends over time. |