Inventories or Stocks – Part 3, Cost Formula

In Example 1 of my previous post, Inventories or Stocks – Part 2, Methods of Recording in General Ledger, the cost of purchasing inventories had been fixed in order to show the effect of two different methods of recording in General Ledger clearly. In reality, cost of inventory purchases fluctuates from time to time. Let’s explore the common ways of calculating the cost of inventories when purchase price fluctuates from time to time – This is called the Cost Formula of inventories. There are three common Cost Formulas for inventories: –

  1. FIFO (First-in-first-out)
  2. Weighted Average
  3. LIFO (Last-in-last-out)

Please take note of the difference between Cost Formulas (FIFO, Weighted Average or LIFO) and the methods of recording inventories in General Ledger (Periodic Method or Perpetual Method). A business entity could choose a combination of the following in recording its inventories: –

Methods of recording in General Ledger

Cost Formula

Combination 1

Periodic

FIFO

Combination 2

Periodic

Weighted Average

Combination 3

Periodic

LIFO

Combination 4

Perpetual

FIFO

Combination 5

Perpetual

Weighted Average

Combination 6

Perpetual

LIFO

As you can see from the above table, the choice of cost formula to be used is independent of how an entity chooses the method of recording inventories in the General Ledger.

Referring to the transactions ABC Co. Ltd. in Example 1 of my previous post, assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

  1. Inventories or stocks on hand as at 31 December 2005 comprised the following:-

    Quantity

    Unit Cost

    Total

    $

    $

    Stock Type A

    100

    5

    500

    Stock Type B

    200

    7

    1,400

    Stock Type C

    250

    20

    5,000

    6,900

  1. 15 January 2006

    Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

  2. 20 January 2006

    Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

  3. 21 March 2006

    Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

  4. 31 July 2006

    Purchase of 50 units of Type A stock at $6 each, on credit. Total purchases were $300.

  5. 30 September 2006

    Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

  6. 30 November 2006

    Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1

Stock Type A

Stock Type B

Stock Type C

Quantity

Quantity

Quantity

Balance as at

1 January 2006

100

200

250

Stock in:
20 January 2006

100

31 March 2006

50

Stock out:
15 January 2006

(50)

21 March 2006

(300)

30 September 2006

(75)

30 November 2006

(150)

Balance as at

31 December 2006

25

100

You would notice that all the above transactions are exactly the same as shown in Example 1 of my previous post except for Transaction e. The purchase cost of Stock A was $6 per unit instead of $5. The difference in this purchase cost requires certain cost formula to determine value of the inventories in hand as at 31 December 2006 and also to determine the cost of goods sold or cost of sales of 75 units of Stock A sold on 30 September 2007. Please take note that the cost of goods sold for the 50 units of Stock A sold on 15 January 2006 makes no difference in terms of the difference cost formula used because the cost per unit of Stock A prior to the sale of this 50 units of Stock A was $5 per unit (assuming the 100 units of Stock A in hand prior to this sale is from the same batch of purchase). The cost of sale and the unit cost of Stock A during the financial year ended 31 December are shown calculated under the three different cost formulas are below: –

FIFO (first-in-first-out)

Under the FIFO cost formula, the earliest batch of inventories would be given the priority over the subsequent batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 2

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 1

Stock out:
30 September 2006

(50)

(25)

(5)

(6)

*(250)

*(150)

Note 2

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

6

150

Note 3

Note 1: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $5 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 2: Under FIFO cost formula, the earliest batch of stock in hand i.e. the 50 units of Stock A @ $5 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand was therefore 25 units of Stock A @ $6.

Note 3: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006.

*: The total of $650 ($250 + $250 + $150) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006.

Weighted Average

Under the Weighted Average cost formula, the weighted average cost of all existing inventories on hand plus the new purchases is calculated and allocated to all inventories on hand (both old and new batch of purchases) with the same weighted average cost calculated. Table 3 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 3

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

100

5.5

550

Note 4

Stock out:
30 September 2006

(75)

(5.5)

*(412.5)

Note 5

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5.5

137.5

Note 6

Note 4: The weighted average cost of $5.5 was calculated by taking the total of the old batch of Stock A (50 x $5 = $250) plus the total of the new batch of Stock A purchased (50 x $6 = $300), divided by the total quantity of new and old stocks – {$250 + $300}/{50units + 50Units} = $5.5.

Note 5: Once the weighted average cost of $5.5 has been determined, the calculation of the cost of goods sold for this 75 units of Stock A is straight forward – 75 units x $5.5

Note 6: The calculation of closing inventories in hand is also straight forward – 25 units x $5.5

*: The total of $662.5 ($250 + $412.5) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

LIFO (last-in-first-out)

Under the LIFO cost formula, the latest batch of inventories would be given the priority over the earlier batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 4

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 7

Stock out:
30 September 2006

(50)

(25)

(6)

(5)

*(300)

*(125)

Note 8

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5

125

Note 9

Note 7: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $6 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 8: Under LIFO cost formula, the latest batch of stock in hand i.e. the 50 units of Stock A @ $6 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand due for stock out was therefore 25 units @ $5 from the earlier batch of Stock A.

Note 9: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006

*: The total of $675 ($250 + $300 + $120) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

The double entries for recording inventories under both the Periodic and Perpetual methods had been shown in my previous post. Of course the figures for Stock A are different from those shown in Example 1 of my previous post, depending on which cost formula is chosen. Figures for Stock B and Stock C remained the same.

Did you notice that the three cost formulas shown above give different cost of goods sold and also different inventory value at the end of the financial year?

Another point to note is that LIFO cost formula is prohibited in some countries.

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2 Responses to “Inventories or Stocks – Part 3, Cost Formula”

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