Inventory costs are constantly changing. Companies must decide how inventory costs will be calculated for the purposes of expensing that inventory when it is sold. There are a number of accepted methods and the method of calculation does not have to match how products actually leave the building. Companies pick a method based on profit and tax objectives. We will look at four methods of calculating costs and the advantages and disadvantages of each method.
There are a number of important terms that will be used when discussing inventory cost. It is crucial that you know this terminology in order to master this topic. All of these terms can be used to describe a dollar value or a number of units.
Beginning inventory is the amount of inventory a company has at the start of the period. Remember that inventory is an asset and appears on the balance sheet. Purchases are additional units of inventory that have been acquired during the period. If you add beginning inventory and purchases, the total is called Goods Available for Sale. Goods Available for Sale is an important concept because we can use this figure as a check figure when doing calculations.
Goods Available for Sale is the total of all the goods that could have been sold during the period. Some of those units will be sold, which is called Cost of Goods Sold. The items that were not sold are still in inventory. Since it is the end of the period, we refer to this as Ending Inventory. If you add cost of goods sold and ending inventory, it should match the amount in Goods Available for Sale. Whenever you are doing calculations involving inventory, you should make sure you have accounted for everything by adding Cost of Goods Sold and Ending Inventory to ensure it matches Goods Available for Sale.
The rules for periodic and perpetual inventory methods still apply when we look at cost determination. Remember that under the periodic inventory system, cost of goods sold is determined at the end of the year via an adjusting entry. Therefore, when entering sales entries, inventory and cost of goods sold is not a factor. Companies that use the perpetual inventory system are always updating inventory balances. Every sales transaction includes the entry for cost of goods sold. Therefore, under the perpetual system, we must figure out the cost of inventory for every sales entry.
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