Average cost method (Weighted Average)
What it is: Inventory costing method that assigns the same average unit cost to all units available for sale during the period.
How it works (basic idea):
$$\text{Average cost per unit}=\frac{\text {Cost of beginning inventory + cost of purchases}} {\text{Units in beginning inventory + units purchased}} $$Then:
COGS = units sold × average cost per unit
Ending inventory = units remaining × average cost per unit
Best for: Similar or interchangeable items (e.g., chemicals, grains, retail items that are hard to track individually).
Effect of rising prices: Results usually fall between FIFO and LIFO for both COGS and ending inventory.
Pros: Smooths price fluctuations; simpler than tracking layers.
Cons: Doesn’t match actual flow of specific items; can hide recent cost changes.
FIFO (First-In, First-Out) method
What it is: Assumes the oldest units purchased are sold first.
COGS: Uses earliest inventory costs.
Ending inventory: Made up of the most recent purchases (latest costs).
Effect of rising prices:
Lower COGS
Higher gross profit
Higher ending inventory
Often higher taxes (because profit is higher)
Pros: Ending inventory is close to current replacement cost; commonly accepted and intuitive.
Cons: In inflation, profit may look higher even though cash costs are rising.
Gross profit method (Inventory estimation method)
What it is: A way to estimate ending inventory and COGS when you don’t have a full physical count (often for interim reports or insurance claims).
Key idea: If you know the gross profit rate, you can estimate COGS.
Steps:
Compute goods available for sale = beginning inventory + purchases
Estimate gross profit = net sales × gross profit rate
Estimate COGS = net sales − estimated gross profit
Estimate ending inventory = goods available for sale − estimated COGS
Best for: Quick estimates, missing inventory situations (fire/theft), interim statements.
Limits: Not acceptable as a replacement for accurate inventory records long-term; accuracy depends on stable gross margin and reliable sales data.
LIFO (Last-In, First-Out) method
What it is: Assumes the most recent units purchased are sold first.
COGS: Uses latest inventory costs.
Ending inventory: Leaves the oldest costs in inventory.
Effect of rising prices:
Higher COGS
Lower gross profit
Lower ending inventory
Often lower taxes (because profit is lower)
Pros: Matches recent costs against current revenues (better “matching” in inflation); potential tax advantage (where allowed).
Cons: Ending inventory can be very outdated (old costs) and more complex (layers); it is not allowed under IFRS (but allowed under US GAAP).
I. Lower of Cost or Net Realizable Value (LCNRV)—US GAAP (mainly FIFO/Weighted Avg.)
Meaning: Inventory is reported at the lower of its cost or NRV.
Purpose (conservatism): Prevents overstating inventory and income when inventory value declines.
When used (GAAP): Applies to inventory measured using FIFO and weighted average. For LIFO and the retail inventory method, GAAP typically uses LCM (lower of cost or market) instead.
Write-down: If NRV < Cost, reduce inventory to NRV and recognize a loss (often in COGS).
Reversal: No reversal of write-downs under US GAAP (generally).
Formulas:
NRV = Estimated Selling Price − Costs of Completion − Costs to Sell
Inventory reported = min(Cost, NRV)
Write-down loss = Cost − NRV (when NRV < Cost)
II. Lower of Cost or Market (LCM)—US GAAP (LIFO + Retail)
Meaning: Inventory is reported at the lower of cost or market.
Key GAAP definition: Market = Replacement Cost, but limited by a ceiling and a floor.
Ceiling and floor (critical):
Ceiling = NRV
Floor = NRV − Normal Profit Margin
How to get “Market” (logic): Start with Replacement Cost. If Replacement Cost > Ceiling → use Ceiling. If Replacement Cost < Floor → use Floor. Otherwise → use Replacement Cost.
Then the final step: compare cost vs. market and use the lower one.
Formulas:
NRV = Estimated Selling Price − Costs of Completion − Costs to Sell
Ceiling = NRV
Floor = NRV − Normal Profit Margin
Market = Replacement Cost (bounded by Floor and Ceiling)
Inventory reported = min(Cost, Market)
III. Net Realizable Value (NRV)
Meaning: Net cash expected from selling inventory after necessary costs.
Used in GAAP: Directly in LCNRV. As the ceiling in the LCM method.
NRV decreases when selling price falls, items become obsolete/damaged, costs to complete increase, or selling costs (shipping, commissions) increase.
Formula: NRV = Estimated Selling Price − Costs of Completion − Costs to Sell
IV. Markup (Pricing: mark up from cost)
Meaning: Amount added to cost to set a selling price.
What it represents: Planned gross profit (before operating expenses).
Two common ways to express it: Markup amount (dollars) or markup percentage (rate).
Formulas:
Markup ($) = Selling Price − Cost
Selling Price = Cost + Markup
Markup % on Cost = Markup ÷ Cost
Gross Margin % on Selling Price = (Selling Price − Cost) ÷ Selling Price
V. Mark-on (Markon)—common in Retail Inventory Method topics
Meaning (most textbooks/classes): Same as markup—the amount added to cost to establish the original retail (ticket) price.
Where it shows up: Retail inventory method problems (cost-to-retail relationships).
Formulas (same structure as markup):
Mark-on ($) = Original Retail Price − Cost
Original Retail Price = Cost + Mark-on
Mark-on % on Cost = Mark-on ÷ Cost
VI. Markdown (Pricing: reduction from original retail price)
Meaning: Reduction of the original retail/selling price to encourage sales (clearance, competition, end-of-season).
Effect: Lowers selling price and reduces expected gross profit.
Common retail forms: Markdown amount ($) or markdown rate.
Formulas:
Markdown ($) = Original Selling Price − New Selling Price
Markdown % = Markdown ÷ Original Selling Price
New Selling Price = Original Selling Price − Markdown
New Selling Price = Original Selling Price × (1 − Markdown %)
VII. Net Realizable Value (NRV)
Meaning: The estimated selling price of inventory in the ordinary course of business minus the estimated costs of completion and the estimated costs necessary to make the sale.
Formula: NRV = Expected selling price − (completion costs + selling costs)
Characteristics / key points: Used to ensure inventory is not reported above the amount expected to be collected from its sale. Common causes of NRV declines include obsolescence, damage, price drops, excess inventory, and rising selling costs. NRV is entity-specific. If inventory is written down and later value recovers, some standards allow reversals (up to the original write-down), while others generally do not.
Journal entry (write-down to NRV): When cost > NRV, write inventory down:
Dr Loss on inventory write-down (sometimes included in COGS)
Cr Inventory (direct method) or Cr Allowance to reduce inventory (contra-inventory method)
Mini-example: Cost 10,000; NRV 9,200 → write-down 800
Dr Loss on inventory write-down 800
Cr Inventory (or Allowance) 800
VIII. Lower of Cost or Market (LCM) (often tested alongside NRV)
Meaning: Inventory is reported at the lower of its historical cost or its market amount.
What “market” means (common classroom definition): Market ≈ replacement cost, but it is constrained by a ceiling (NRV) and a floor (NRV − normal profit margin).
Logic: Compute replacement cost, apply ceiling/floor limits, and compare cost vs. market (bounded) to choose the lower.
Journal entry (if market < cost):
Dr Loss on inventory write-down (or COGS)
Cr Inventory (or Allowance to reduce inventory)
IX. Periodic Inventory System
Meaning: A system where inventory and cost of goods sold (COGS) are not updated continuously. Inventory is determined at period-end using a physical count.
Characteristics / key points: Purchases are recorded in a Purchases account during the period. COGS is calculated at the end of the period. Simpler recordkeeping; less timely information for inventory/COGS during the period.
Formula: COGS = Beginning Inventory + Net Purchases − Ending Inventory
Net Purchases calculation: Purchases − Returns/Allowances − Discounts + Freight-in
Journal entries (typical):
Purchase of merchandise on account: Dr Purchases / Cr. Accounts Payable
Freight-in (if tracked separately): Dr Freight-in / Cr. Cash or Accounts Payable
Sale on account (no COGS entry at sale time): Dr Accounts Receivable / Cr. Sales Revenue
Period-end adjusting/closing idea (conceptual): Update inventory to the physical-count ending balance and compute COGS.
X. Perpetual Inventory System
Meaning: A system where inventory and COGS are updated continuously with each purchase and each sale.
Characteristics / key points: The inventory account shows a running balance. Provides real-time gross profit and inventory information. Still needs periodic physical counts to confirm accuracy and detect shrinkage.
Journal entries (typical):
Purchase on account: Dr Inventory / Cr. Accounts Payable
Sale on account (two entries): 1) Dr Accounts Receivable / Cr. Sales Revenue and 2) Dr Cost of Goods Sold / Cr. Inventory
Customer return (typical two-part return): 1) Dr Sales Returns & Allowances / Cr. Accounts Receivable or Cash and 2) Dr Inventory / Cr. Cost of Goods Sold
XI. Physical Inventory (Count)
Meaning: The process of counting/weighting/measuring inventory on hand to determine actual quantities.
Characteristics / key points: Needed to determine ending inventory under periodic systems. Used under perpetual systems to verify records and reveal shrinkage. Key control issues include cutoff (goods in transit), damaged/obsolete items, double-counting, and segregation of duties.
Journal entry (shrinkage adjustment under perpetual): If physical count is less than the book balance:
Dr Inventory Shrinkage (or COGS)
Cr Inventory
XII. Retail Inventory Method
Meaning: An estimation method that converts ending inventory at retail to an estimate at cost using a cost-to-retail percentage.
Characteristics / key points: Useful for high-volume retailers with many items. Requires records of inventory at both cost and retail. Often used for interim reporting and as a reasonableness check.
Core steps:
Compute goods available for sale at cost and at retail.
Compute cost-to-retail %: Cost-to-retail % = Goods available at cost ÷ Goods available at retail
Estimate ending inventory at retail: Ending inventory (retail) = Goods available (retail) − Sales (retail)
Convert to cost: Ending inventory (cost) = Ending inventory (retail) × cost-to-retail %
Journal entry: Not a special “retail” entry by itself; record purchases/sales normally and make the usual end-of-period inventory/COGS adjustment based on the computed ending inventory.
XIII. Specific Identification Method
Meaning: A method that assigns the actual cost of each specific item to COGS when sold and to ending inventory when unsold.
Characteristics / key points: Best for unique, high-value items (cars, jewelry, custom equipment). Most precise matching of costs to revenues. Requires detailed tracking (serial numbers, tags, RFID).
Journal entry (perpetual sale):
Dr Accounts Receivable or Cash / Cr. Sales Revenue
Dr Cost of Goods Sold (actual cost of the specific item sold) / Cr. Inventory
XIV. Weighted Average Cost Method
Meaning: A method that assigns inventory costs using an average cost per unit.
Characteristics / key points: Smooths price fluctuations. Results often fall between FIFO and LIFO in periods of changing prices. Two common versions are periodic weighted average (one average for the whole period) and moving average under perpetual (recomputed after each purchase).
Calculations:
Periodic average cost per unit: Average cost per unit = Total cost of goods available ÷ Total units available
Ending inventory = Ending units × average cost
COGS = Units sold × average cost
Perpetual moving average: Recalculate the average after each purchase. Each sale uses the current moving-average unit cost.
Journal entry (perpetual sale):
Dr Accounts Receivable or Cash / Cr. Sales Revenue
Dr Cost of Goods Sold (units sold × current average cost) / Cr. Inventory