6 01 Inventory Control Methods Understand Inventory Control

6. 01 Inventory Control Methods Understand Inventory Control Methods Power. Point #3

Inventory Control Methods � Help businesses account for Ending Inventory and help determine Cost of Goods Sold � If Inventory consists of large, identifiable items, it is easy to compute the above. � If Inventory consists of lots of items that are not specifically identifiable, such as in a hardware store, it is not very easy to compute the above. � Businesses use Inventory Control Methods to help with these computations.

Assumptions � Because of fluctuations in purchase price of the inventory, businesses must make assumptions about which items have sold and which remain. � These ◦ ◦ Methods are: Specific Identification First In First Out Last In Last Out Weighted Average

Specific Identification � The actual cost of each item is assigned to the item. � Firms that sell big ticket items such as cars, appliances, or furniture may use specific identification. � This method is rarely used in practice today.

First In First Out � Based on the assumption that the first items purchased are the first items sold � Assumes the newest acquired items remain in inventory � During periods of inflation, FIFO will result in the lowest Cost of Goods Sold and the highest income.

Last In First Out � Based on the assumption that the last items purchased are the first items sold � Assumes the oldest acquired items remain in inventory. � During periods of inflation, the use of LIFO results in the highest Cost of Goods Sold and the lowest income.

Weighted Average � Assigns an average cost to each unit in inventory � This average unit price is calculated prior to each sale. � This method results in a Cost of Goods Sold amount that is between the FIFO and LIFO amounts.

Lower of Cost or Market � Lower of Cost or Market is not an inventory method, it is an application of the GAAP principle of Conservatism. � Per GAAP, inventory is valued at historical cost. � Sometimes, the original cost of the ending inventory is more than its replacement cost. � If inventory has decreased significantly below historical cost, the Lower of Cost or Market is used.

Lower of Cost or Market (cont’d) � First, inventory is calculated by one of the inventory control methods. � Next, inventory value is compared to market value to determine if an adjustment should be made. � The difference is charged to the Cost of Goods Sold account or to a special Loss Account if material.

Questions for Understanding/Discussion � Why would a hardware store opt to account for inventory using an inventory control method rather than count each individual bin of nails, screws, and bolts? � Explain the differences between the four inventory control methods? � Summarize each of the four methods in your own words. � Explain why the lower of cost or market method is used by companies.