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Perpetual Inventory System

In document Principles of Financial Accounting (Page 117-122)

4.1 Inventory

4.1.1 Perpetual Inventory System

INVENTORY GRIDS

By entering transactions into a cost grid, you can organize your data to easily determine Cost of Merchandise Sold amounts and Merchandise Inventory balances after every purchase and sale. The grids show increases in Merchandise Inventory due to purchases, decreases in Merchandise Inventory due to sales, and the running Merchandise Inventory balance.

The following grid organizes the purchases and sales of a merchandiser for one of its products. It is essentially an expanded Merchandise Inventory account ledger. Not only does it show the dollar amount for each transaction and the updated running balance in dollars, but it also keeps track of the number of items

SAMPLE INVENTORY COST GRID

Date Purchases Cost of Merchandise Sold Inventory Balance Units Cost Total Units Cost Total Units Cost Total

6/1 10 $4 $40

6/5 1 $4 $4 9 $4 $36

6/10 10 $5 $50 9 $4 $36

10 $5 $50

The Purchases columns show the details about items that were bought on different dates for resale to customers. Entries in the Purchases columns are the same regardless of the inventory valuation method selected. For a purchase, there is a debit to Merchandise Inventory and total inventory increases.

The Cost of Merchandise Sold columns show the detail about the order in which items are withdrawn from inventory for each sale. The amounts in these columns will vary based on whether the method is FIFO, LIFO, or average cost. For a sale, there is a debit to Cost of Merchandise Sold and total inventory decreases.

The Inventory Balance columns keep a running total of the number of items and their costs on each date. Each purchase is added to any inventory balance that already appears there. With a purchase, it is a good practice to first copy down what was in stock on the previous date in the Inventory Balance columns and add the new purchase below that. This clearly shows what is in stock on any given date. Each sale reduces the inventory balance by the cost of merchandise sold amount. NOTE: Only costs are entered into the grid; not the price that you sell the merchandise for to customers. If you are given the selling price, you can also determine the amount of sales and gross profit amounts outside of the grid.

There is a journal entry that corresponds to each purchase and sale. One key reason for the grid is that it enables you to determine the amounts for the cost of merchandise sold for each sale.

FIFO under the perpetual inventory system—FIFO (first-In, first-out) is a

method of inventory valuation where the cost of the items purchased earliest is used in Cost of Merchandise Sold when one item is resold. The balance in Merchandise Inventory, which includes those items still available for sale, is comprised of the costs of those items purchased most recently.

Four inventory questions under FIFO:

1. What is total sales? 19 units, $190

(1 + 12 + 6) = 19 units sold x $10 per unit

2. What is total cost of merchandise sold? $85

($4 + $36 + $15 + $30) from cost of merchandise sold column

3. What is gross profit? $105

Sales – cost of merchandise sold is $190 - $85

4. What is the ending inventory balance? 11 units, $65

6/30 inventory balance amounts in cost grid

6/1 The inventory balance that is given is entered. This is carried over from the previous month. 6/5 One unit is sold. Since all 10 units in stock cost

$4, the only choice is a $4 cost for that item in the Cost of Merchandise Sold columns. This is deducted from the inventory balance.

6/10 Purchases are entered in the Purchases columns and added to the inventory balance.

6/16 Now it is important to know you are using FIFO. The customer ordered 12 items. You have 19 in stock at two different costs. Under FIFO you use the “oldest” ones first – the $4 items. You sell all 9 of those and then need 3 items that cost $5 to complete the order. You use two lines in the Cost of Merchandise Sold columns – one for each unit cost. This is deducted from the inventory balance.

6/22 Purchases are entered in the Purchases columns and added to the inventory balance.

LIFO under the perpetual inventory system—LIFO (last-in, first-out)

is a method of inventory valuation where the cost of the item purchased most recently is used in Cost of Merchandise Sold when one item is resold. The balance in Merchandise Inventory, which includes those items still available for sale, is comprised of the costs of those items purchased earliest.

Four inventory questions under LIFO:

1. What is total sales? 19 units, $190

(1 + 12 + 6) = 19 units sold x $10 per unit

2. What is total cost of merchandise sold? $98

($4 + $50 + $8 + $36) from cost of merchandise sold column

3. What is gross profit? $92

Sales – cost of merchandise sold is $190 - $98

4. What is the ending inventory balance? 11 units, $52

6/30 inventory balance amounts in cost grid

6/1 The inventory balance that is given is entered. This is carried over from the previous month. 6/5 One unit is sold. Since all 10 units in stock cost

$4, the only choice is a $4 cost for that item in the Cost of Merchandise Sold columns. This is deducted from the inventory balance.

6/10 Purchases are entered in the Purchases columns and added to the inventory balance.

6/16 Now it is important to know you are using LIFO. The customer ordered 12 items. You have 19 in stock at two different costs. Under LIFO you use the “newest” ones first – the $5 items. You sell all 10 of those and then need 2 items that cost $4 to complete the order. You use two lines in the Cost of Merchandise Sold columns – one for each unit cost. This is deducted from the inventory balance.

6/22 Purchases are entered in the Purchases columns and added to the inventory balance.

6/30 The customer ordered 6 items. You have 17 in stock at two different costs. Under LIFO you use the “newest” ones first - the $6 items. You sell 6 of those and enter this in the Cost of Merchandise Sold. This is deducted from the inventory balance.

Average cost under the perpetual inventory system—Average cost is a

method of inventory valuation where each time there is a purchase or sale, the dollar value of the remaining inventory on hand is divided by the number of units in stock to arrive at an average cost per unit. Likewise, the cost of merchandise sold is determined by using an average cost per unit.

Four inventory questions under LIFO:

1. What is total sales? 19 units, $190.00

(1 + 12 + 6) = 19 units sold x $10 per unit

2. What is total cost of merchandise sold? $90.70

($4 + $54.36 + $32.34) from cost of merchandise sold column

3. What is gross profit? $99.30

Sales – cost of merchandise sold is $190.00 - $90.70 4. What is the ending inventory balance? 11 units, $58.74

6/30 inventory balance amounts in cost grid

6/1 The inventory balance that is given is entered. This is carried over from the previous month. 6/5 One unit is sold. Since all 10 units in stock cost

$4, the only choice is a $4 cost for that item in the Cost of Merchandise Sold columns. This is deducted from the inventory balance.

6/10 Purchases are entered in the Purchases columns and added to the inventory balance.

6/16 Now it is important to know you are using the average cost method. The customer ordered 12 items. You have 19 in stock at an average cost of $4.53 per unit. The amount of 12 x $4.53 is deducted from the inventory balance.

6/22 Purchases are entered in the Purchases columns and added to the inventory balance.

6/30 The customer ordered 6 items. You have 17 in stock at an average cost of $5.39 per unit. The amount of 6 x $5.39 is deducted from the

The results of the preceding example for both FIFO and LIFO under the perpetual inventory system can be summarized in four questions.

Four inventory questions FIFO LIFO Average cost

1. What is total sales? (19 units) $190.00 $190.00 $190.00 2. What is total cost of merchandise sold? (19 units) 85.00 98.00 90.70 3. What is gross profit? 105.00 92.00 99.30 4. What is the ending inventory balance? (11 units) 65.00 52.00 58.74

Under all three methods, 19 units were sold and total sales were $190. Notice, however, that under FIFO the 19 units COST $85, under LIFO these same 19 units COST $98, and under average cost these same 19 units COST $90.70. This is a $13 difference between the highest and lowest costing method.

Gross profit is also different among the three methods. Because less cost is deducted from sales under the FIFO method, gross profit is $13 higher under FIFO than it is for LIFO.

That $13 difference also appears in the ending inventory balances. Since the cost of merchandise sold was lower under FIFO than it was under LIFO and average cost, the ending inventory balance under FIFO is higher that with the other two methods.

To summarize, there is a $13 difference between FIFO and LIFO in the cost of goods sold and ending inventory amounts. FIFO includes that $13 as part of ending inventory; LIFO considers that $13 to be part of cost of merchandise sold. NOTE: The pattern above will result when costs are rising over time. In this example, they increased from $4 to $5 to $6. If costs decrease over time, the results will be the opposite: LIFO would include the difference as part of ending inventory and FIFO would consider the difference to be part of cost of merchandise sold.

The results for the average cost method typically fall between those for LIFO and FIFO.

In document Principles of Financial Accounting (Page 117-122)