Inventory
Systems and cost flow
A perpetual system updates inventory at every purchase and sale; a periodic system computes cost of goods sold only at period end as beginning inventory plus purchases minus ending inventory. Cost flow assumptions are specific identification, FIFO, LIFO, and weighted average. The assumption chosen need not match the physical movement of goods.
Price effects
When prices are rising, LIFO produces the highest cost of goods sold and the lowest ending inventory, net income, and tax; FIFO produces the lowest COGS and the highest ending inventory and income. Falling prices reverse every one of those relationships. LIFO layers and LIFO liquidation distort year-to-year comparisons.
Traps
- Ownership: goods in transit FOB shipping point belong to the buyer; FOB destination, to the seller. Consigned goods stay with the consignor, never the consignee.
- Freight-in is part of inventory cost; freight-out is a selling expense.
- Lower of cost or market is applied when value falls below cost.
- Ending inventory errors: overstating ending inventory understates COGS and overstates income this period, then reverses next period - it self-corrects after two periods, but the intervening retained earnings figure is wrong.
Worked example
Begin with 100 units at $10, buy 100 at $14, sell 150. Goods available = $2,400. FIFO COGS = (100 × $10) + (50 × $14) = $1,700; ending inventory = 50 × $14 = $700. LIFO COGS = (100 × $14) + (50 × $10) = $1,900; ending inventory = 50 × $10 = $500.
Rule of thumb: COGS plus ending inventory must always equal cost of goods available for sale.