## 2. Application of different cost flow methods

So far we have been talking about two inventory layers with one inventory item (a Ford) in each. In real life companies have multiple inventory layers. In addition, companies can choose between inventory cost flow methods using either perpetual or periodic systems. Combinations of the cost flow methods and systems may result in different numbers in the income statement and on the balance sheet. The following examples will give you a better understanding of inventory cost allocation concepts.

In the discussion below, we will not consider the specific identification method because it is simple and does not require detailed explanations.

Assume that a company named Brid's Drills has the following beginning balance sheet numbers:

Illustration 3: Beginning balances for Brid's Drills

 Assets Claims Cash + Inventory = Contributed Capital + Retained Earnings \$4,500 + \$1,500 = \$4,500 + \$1,500

Consider the following transactions taking place in 20X7:

1. Two (2) purchases of drills were made.
2. One (1) cash sale of the drills took place.

The table below shows the quantities and costs of inventory layers:

 Beginning Inventory 100 units x \$15 = \$1,500 (at cost) Purchase One 120 units x \$18 = \$2,160 (at cost) Purchase Two 80 units   x \$20 = \$1,600 (at cost) Sale 270 units x \$40 = \$10,800 (at selling price) Cost of Sale 270 units x TBD* = TBD* (at cost)

* TBD - cost to be determined, read further.

In addition, at the end of 20X7 the company paid income taxes based on 30% of net income.

The two inventory purchases have the same effect on the company's financial records under any cost flow method (FIFO, LIFO or weighted-average). The inventory cost balance increases by \$3,760 (\$2,160 + \$1,600) and quantity on hand increases by 200 (120 + 80) units.

The two other transactions (sale and payment of income taxes) differ in amounts under the FIFO, LIFO and weighted-average methods. Let us look at them in more detail.

## 2.1. Example of FIFO cost flow method

When a sale takes place, two entries are usually made in accounting books. One is for revenue recognition and the other one is for expense (cost of sales or cost of goods sold) recognition. In our example, the revenue recognition entry has the same sales amount regardless of the cost flow method which is \$10,800 for 270 drills. The revenue recognition increases both assets (Cash) and equity (by increasing Sales Revenue). This is as asset source transaction.

The cost of goods sold will be different under different cost flow methods. Under FIFO, the cost of goods sold is determined by adding up the costs of 270 drills acquired by Brid's Drills first. The cost of the first 270 units available on hand for Brid's Drills is calculated as follows:

Illustration 4: Brid's Drills cost of goods sold under FIFO

 Beginning Inventory 100 units x \$15 = \$1,500 Purchase One 120 units x \$18 = \$2,160 Purchase Two 50 units   x \$20 = \$1,000 Total 270 units \$4,660

The recognition of cost of goods sold decreases assets (Inventory) and equity (by increasing Cost of Goods Sold). The 30 units from the second purchase remain in the Inventory account.

The gross margin and net income equal \$6,140 (\$10,800 - \$4,660). The gross margin and net income are the same in this simplified case because there are no other expenses besides the cost of goods sold. To determine the income tax expense, we need to multiple the net income by the income tax rate. The rate is 30%, so the income tax is \$1,842 (\$6,140 x 30%). The effect of the income tax payment is a decrease in assets (Cash) and equity (by increasing Income Tax Expenses).

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