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Inventory Cost Flow Assumptions

Inventory Cost Flow Assumptions

Author: Evan McLaughlin
Description:

In this lesson, the student will learn about inventory cost flow assumptions.

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Tutorial

"Inventory Cost Flow Assumptions"

Source: Instrumental “Drops of H2O ( The Filtered Water Treatment )" by J.Lang (feat. Airtone),” Creative Commons, http://ccmixter.org/files/djlang59/37792

Video Transcription

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Hey, everyone, and welcome to our video today on inventory cost flow assumptions. So what is today's video about? Well, we're going to discuss the inventory cost flow assumptions, and we're going to do a review. We're going to review FIFO, LIFO, and weighted average. So let's go ahead and get started.

Let's start with our FIFO. So FIFO-- what is FIFO? Well, we already mentioned that it's an inventory valuation method, and then what does it stand for? What does FIFO stand for? It's first in, first out. You might be asking yourself, what does that mean? That means goods are assumed to be sold oldest to newest. So the goods that were purchased first are the first to be sold. And the newest or latest goods are assumed to remain in our inventory.

So what is the argument for FIFO? Why should we use FIFO? Well, FIFO most closely resembles the physical flow of goods. Examples would be grocery stores and electronic stores. So they want to take the goods that they purchased first, so their oldest purchases, and they want to sell those first. In the case of a grocery store, they want to sell the oldest merchandise first, because it's going to spoil, or it's going to be bad. So that's why FIFO more closely resembles the physical flow of goods.

So now let's talk about LIFO. What is LIFO? Well, it's also an inventory valuation method. And what does it stand for? LIFO stands for last in, first out. So last in, first out. Now what does that mean? That means that goods are assumed to be sold newest to oldest. So the goods that were purchased last or most recently are the first to be sold. And then the oldest goods, so the goods that were purchased first, are assumed to remain in inventory.

So what's the argument for LIFO? Why should we use LIFO? Well, the argument for LIFO is that matching, so that LIFO matches current costs of items with current sales revenue. So LIFO, because the newer goods are what's getting recorded to our sales, is matching the current cost with the current revenues. So that's the argument for LIFO-- that it matches current costs with current revenues.

Now let's talk about the weighted average method. What is the weighted average method? The weighted average method is also an inventory valuation method, and it's based on the average cost per unit. So the weighted average method is based on average cost per unit. So what does that mean? That means under the weighted average method, it's based on total cost and total units.

So what's the total cost of our inventory? What's the total number of units that we have? And if we take the total cost of the units divided by the total units, that's going to give us the total cost per unit, or the average cost per unit. And that's how we determine the cost per unit in weighted average method.

There is no concern for the timing of inventory purchases, so it doesn't matter if our purchases were the oldest or the newest, because we're looking at everything on a total basis. So what's the argument for the weighted average method? Well, the argument is that there's a lot of complexity in inventory. So it can be difficult to monitor or measure the exact flow of inventory. So it's difficult to know in some circumstances if your oldest goods were just sold or if your most recent purchases were just sold. So that's the argument for the weighted average method.

Let's talk about one more method-- specific identification method. So what is it? What's specific identification? Well, it's also an inventory valuation method, and it's useful if your inventory is exactly known. So if you can know your exact inventory, if you have a low volume business, and you're able to specifically identify which items are sold and which remain in inventory.

An example of that would be car dealerships. So you have a car dealership that only has, let's say eight cars, and you can count the eight cars, then you don't need to worry about FIFO, LIFO, or the weighted average method. And the specific identification method is not very common, because it's really only useful if, again, you have that low volume type business.

So let's summarize what we talked about today in a nutshell. We did a review, and we reviewed inventory valuation methods. We talked about FIFO, first in, first out, LIFO, last in, first out, the weighted average method, as well as the specific identification method.

I hope everybody enjoyed this video, and I hope to see you next time.