Source: Chapter 8, Intermediate Financial Accounting II (Penn State)
Tags: FIFO, LIFO, average cost, specific identification, dollar-value LIFO, DVL, LIFO liquidation, gross profit ratio, inventory turnover, GAAP vs IFRS, ACCTG 471
Difficulty: Intermediate-Advanced | Prerequisites: Part 1 of these notes (inventory systems, perpetual vs. periodic, journal entries)
Once you understand how inventory is tracked (perpetual vs. periodic) and which goods belong in your count (Part 1), the next question is: at what cost? When a company buys the same product at different prices over time, it must choose a cost flow assumption to assign costs to COGS and ending inventory. That choice directly affects reported profit and the balance sheet. This part covers the four main methods (specific identification, average cost, FIFO, LIFO), the effects of rising and falling prices, LIFO-specific topics (liquidations, pools, dollar-value LIFO), and two key inventory ratios.
Cost flow assumptions determine which costs go to COGS and which stay in ending inventory. FIFO assigns oldest costs to COGS; LIFO assigns newest costs. During rising prices, LIFO produces higher COGS and lower income. Average cost splits the difference. Dollar-value LIFO simplifies LIFO by tracking inventory in dollar layers rather than physical units. GAAP permits LIFO; IFRS does not.
Specific identification method
Matches each unit sold (or on hand) with its actual purchase cost. The most accurate method for recognising COGS. In simple terms, you look up the exact invoice for each item you sell. Practical only for unique, high-value goods like cars or jewellery.
Average cost method
Assigns the same weighted-average unit cost to both COGS and ending inventory. The average is calculated from the total cost of goods available for sale divided by the total units available. Think of it as blending all purchase prices into one pool and pulling from that pool for every sale.
Periodic average cost (weighted average)
The average unit cost is computed once, at the end of the period, using total COGAS divided by total units available for sale.
Perpetual average cost (moving average)
A new average unit cost is recalculated after every purchase. Sales during the period use whatever the moving average is at the time of the sale.
FIFO (first-in, first-out)
Assumes the oldest units are sold first. Ending inventory consists of the most recently purchased units. In simple terms, what came in first goes out first, like items on a supermarket shelf.
LIFO (last-in, first-out)
Assumes the most recently purchased units are sold first. Ending inventory consists of the oldest units. Think of it as pulling stock from the top of a pile: the newest arrivals go out, and the bottom of the pile stays.
LIFO liquidation
Occurs when a LIFO company sells more units than it purchases in a period, dipping into old, low-cost inventory layers. This causes COGS to reflect outdated costs and can artificially inflate net income.
LIFO inventory pool
A group of physically similar inventory items treated as a single unit for LIFO purposes. All purchases within a pool during a period are treated as if made at the same time and at the pool's average cost.
Dollar-value LIFO (DVL)
A LIFO method that measures inventory layers in dollar amounts rather than physical units. Each year's layer is stated at base-year prices, then converted back to current prices using a cost index. In simple terms, instead of tracking individual items, you track the total dollar value of the pool and adjust for inflation.
Cost index
The ratio of current-year cost to base-year cost for a pool. Used to deflate current-year ending inventory to base-year dollars so layers from different years can be compared on the same basis. Formula: Cost index = Cost in layer year / Cost in base year.
Gross profit ratio
Gross profit divided by net sales. Shows the percentage of each sales pound available to cover operating expenses and generate profit.
Inventory turnover ratio
COGS divided by average inventory. Measures how many times the average inventory balance is sold during the period. A higher ratio generally signals more efficient inventory management.
The most accurate method: each unit sold is matched with its actual purchase cost.
Practical only for companies selling unique, expensive items with low sales volume (e.g. car dealerships, art galleries).
Each item has a traceable identifier (serial number, VIN) linked to its invoice.
Periodic average cost: compute the weighted-average unit cost once, at period end.
Weighted-average unit cost = Cost of goods available for sale / Quantity available for sale
COGS = Units sold x Weighted-average unit cost
Ending inventory = Units on hand x Weighted-average unit cost
Example (periodic): Beginning inventory: 4,000 units at $5.50 = $22,000. Purchases: 7,000 units at various prices = $49,500. Total COGAS = $71,500 for 11,000 units.
Weighted-average unit cost = $71,500 / 11,000 = $6.50
COGS (6,500 units sold) = 6,500 x $6.50 = $42,250
Ending inventory (4,500 units) = 4,500 x $6.50 = $29,250
Perpetual average cost (moving average): a new average is recalculated after every purchase.
After each purchase: new average = (previous inventory balance + cost of new purchase) / total units on hand
Sales between purchases use the current moving average as the unit cost for COGS.
The oldest costs flow to COGS; the newest costs remain in ending inventory.
Periodic FIFO and perpetual FIFO produce the same results because the oldest costs are always used first regardless of when the calculation is done.
Ending inventory under FIFO is valued at the most recent purchase prices, which closely approximates current replacement cost on the balance sheet.
The newest costs flow to COGS; the oldest costs remain in ending inventory.
Periodic LIFO and perpetual LIFO also produce the same results.
LIFO better matches current costs against current revenues on the income statement, but ending inventory may be stated at very old costs on the balance sheet.
During rising costs:
LIFO: higher COGS, lower ending inventory, lower net income
FIFO: lower COGS, higher ending inventory, higher net income
During declining costs:
FIFO: higher COGS, lower ending inventory, lower net income
LIFO: lower COGS, higher ending inventory, higher net income
The average cost method always falls between FIFO and LIFO for both COGS and ending inventory.
US GAAP: LIFO is an acceptable inventory valuation method.
IFRS: LIFO is not permitted. Companies reporting under IFRS must use FIFO, weighted average, or specific identification.
Some LIFO companies maintain internal records using FIFO or average cost, then adjust to LIFO for external reporting. Supplemental disclosures allow users to convert LIFO figures to what they would have been under FIFO.
When a LIFO company sells more units than it buys in a period, it dips into old inventory layers with outdated (usually lower) costs.
This causes COGS to include old, low costs matched against current selling prices, which inflates gross profit and net income.
If costs have been rising, a LIFO liquidation produces higher net income than normal. If costs have been declining, it produces lower net income.
Inventory units are grouped into pools based on physical similarity.
Within each pool, all purchases during a period are treated as having been made at the same time and at the same cost.
Individual unit costs are converted to an average cost for the pool.
If ending inventory quantity for the pool increases: ending inventory = beginning inventory + one new layer added at the pool's average cost for the period.
DVL measures inventory layers in dollars rather than physical units, which allows a large variety of goods to be combined into one pool.
Advantages:
Simplifies recordkeeping (no need to track individual units)
Reduces the probability of LIFO liquidations (because increases in one item can offset decreases in another within the same pool)
Three-step DVL technique:
Convert ending inventory at year-end costs to base-year costs. Divide the ending inventory valued at current costs by the cost index for that year.
Identify the layers. Compare the ending inventory at base-year costs to the beginning inventory at base-year costs. If it grew, a new layer was added. If it shrank, the most recent layer(s) have been partially or fully liquidated.
Convert each layer back to layer-year cost. Multiply each layer (stated at base-year cost) by the cost index for the year that layer was created. Sum all layers to get the DVL ending inventory.
Worked example:
ABC Co. adopts DVL LIFO on 1 January 2012 with inventory of $10,000 (base year index = 1.00).
End of 2012: Ending inventory at current cost = $10,500. Cost index = 1.02.
Step 1: $10,500 / 1.02 = $10,294 at base-year cost
Step 2: $10,294 - $10,000 = $294 new layer added (at base-year cost)
Step 3: Base layer $10,000 x 1.00 = $10,000. 2012 layer $294 x 1.02 = $300. DVL ending inventory = $10,300.
End of 2013: Ending inventory at current cost = $15,500. Cost index = 1.30.
Step 1: $15,500 / 1.30 = $11,923 at base-year cost (note: the source rounds differently; using the source figures: $15,500 / 1.30 = approximately $11,923; the lecture notes state $11,294 which uses a different rounding)
Step 2 (using the lecture's figures): $11,294 - $10,294 = $1,000 (adding to the two existing layers); per the lecture notes the layers are: base $10,000, 2012 layer $294, 2013 layer $1,629 (totalling $11,923 at base)
Step 3: $10,000 x 1.00 = $10,000. $294 x 1.02 = $300. $1,629 x 1.30 = $2,118. DVL ending inventory = $12,418.
If ending inventory at base-year cost is less than beginning inventory at base-year cost, the most recent layer is reduced or eliminated first (LIFO order). No new layer is added.
Gross profit ratio = Gross profit / Net sales
Shows the percentage of each sales dollar available to cover expenses beyond COGS.
A higher ratio means a higher markup. A declining ratio may signal that the company cannot pass rising costs on to customers, or that selling prices are falling without matching cost reductions.
Inventory turnover = COGS / Average inventory
Measures how many times the average inventory balance turns over during the period.
A higher ratio generally means more efficient inventory management and stronger profitability.
A declining ratio may indicate obsolete or slow-moving stock, or weak sales efforts.
Weighted-average unit cost (periodic): COGAS / Quantity available for sale
Moving average (perpetual): (Previous inventory balance + Cost of new purchase) / Total units on hand
Cost index (DVL): Cost in layer year / Cost in base year
Ending inventory at base-year cost (DVL): Ending inventory at current cost / Cost index for the year
DVL ending inventory: Sum of (each layer at base-year cost x that layer's cost index)
Gross profit ratio: Gross profit / Net sales
Inventory turnover ratio: COGS / Average inventory
Students often think periodic FIFO and perpetual FIFO produce different results. They do not. FIFO always uses the oldest costs first, so the timing of the calculation is irrelevant.
Students assume LIFO is always better because it lowers taxes (through lower net income). That is only true when costs are rising. When costs are declining, LIFO produces higher income and higher taxes than FIFO.
Students confuse the direction of the effect: during rising costs, LIFO gives higher COGS, not higher ending inventory. A useful mnemonic is "LIFO = Last costs to COGS = highest COGS when prices rise."
Students forget that IFRS does not allow LIFO. Any exam question involving an IFRS company eliminates LIFO as an option.
In dollar-value LIFO, students sometimes apply the cost index in the wrong direction. The index is used to deflate (divide) current-year inventory down to base-year dollars, and then to inflate (multiply) each layer back up to its own year's dollars.
Know which method produces the highest and lowest COGS and ending inventory under rising costs and under declining costs. This is tested constantly.
Be able to compute weighted-average unit cost and apply it to determine both COGS and ending inventory.
Dollar-value LIFO: expect a calculation problem. Practise the three-step technique until you can do it without notes.
The GAAP vs. IFRS distinction on LIFO is a common multiple-choice question.
LIFO liquidation and its effect on income is a favourite exam topic.
During rising prices, LIFO leads to lower operating earnings. The lecture notes confirm this was tested in class.
Specific identification is best for high-cost, unique items. This was also confirmed as a class multiple-choice question.
True or false: FIFO produces the same results under both perpetual and periodic systems. (True)
Fill in the blank: During rising costs, ______ produces the highest COGS. (LIFO)
True or false: IFRS permits the use of LIFO. (False)
Fill in the blank: In dollar-value LIFO, ending inventory at current cost is divided by the ______ to convert it to base-year cost. (Cost index)
True or false: A LIFO liquidation during a period of rising costs will decrease net income. (False; it increases net income)
Q: A company has 11,000 units available for sale at a total cost of $71,500. It sells 6,500 units. Under the periodic average cost method, what is COGS?
A: Weighted-average unit cost = $71,500 / 11,000 = $6.50. COGS = 6,500 x $6.50 = $42,250.
Q: During a period of rising prices, which inventory costing method will generally lead to the lowest operating earnings?
A: LIFO. The most recently purchased (and most expensive) units are assigned to COGS, increasing expenses and reducing gross profit.
Q: Specific identification is an inventory costing method that is best suited for which type of goods?
A: High-cost, unique items with low sales volumes (e.g. automobiles, fine art, custom machinery).
Q: ABC Co. uses dollar-value LIFO. Base-year inventory is $10,000 (index 1.00). At year end, current-cost inventory is $10,500 and the cost index is 1.02. What is the DVL ending inventory?
A: Step 1: $10,500 / 1.02 = $10,294 (base-year cost). Step 2: new layer = $10,294 - $10,000 = $294. Step 3: base layer $10,000 x 1.00 = $10,000; 2012 layer $294 x 1.02 = $300. DVL ending inventory = $10,300.
Q: What happens to net income when a LIFO company experiences a LIFO liquidation during a period of rising costs?
A: Net income increases. The company dips into old, lower-cost inventory layers, which reduces COGS relative to what it would have been had the company maintained its inventory levels.
Q: A company's gross profit is $400,000 and net sales are $1,000,000. What is the gross profit ratio?
A: $400,000 / $1,000,000 = 40%.
The cost flow assumptions covered here build directly on the perpetual and periodic inventory systems from Part 1. Understanding which system is in use matters because it determines when and how the average cost is calculated (periodic vs. moving average).
These methods also connect to lower-of-cost-or-net-realisable-value (LCNRV) testing, typically in Chapter 9, where the cost figure being compared to NRV depends on which cost flow method the company uses. Dollar-value LIFO is particularly relevant for companies reporting under US GAAP that hold large, diverse inventories.
The inventory turnover ratio ties into broader financial statement analysis and ratio interpretation covered later in the course.
FIFO, first-in first-out, LIFO, last-in first-out, average cost, weighted average, moving average, specific identification, cost flow assumptions, inventory costing methods, LIFO liquidation, LIFO reserve, LIFO pools, dollar-value LIFO, DVL LIFO, cost index, base-year cost, layer-year cost, gross profit ratio, inventory turnover ratio, GAAP vs IFRS inventory, ACCTG 471, intermediate accounting, inventory valuation