FIFO and weighted average: the cost of units sold

Two inventory reports can show the same units sold and still report different costs of goods sold. The cost rule determines which recorded purchase costs are assigned to the sale and which remain with unsold stock. That distinction can change gross profit without changing a shipment or a payment.

One stock record, two purchase costs

Consider an invented retailer with 100 identical, interchangeable units at the start of one reporting period. Their complete recorded cost is $10 each, or $1,000, paid before this period began. Before making any sales, the retailer buys another 100 units of the same item at a complete recorded cost of $14 each, totaling $1,400.

The retailer sells 120 units for $20 each and collects all $2,400 during the period. It pays the new purchase's $1,400 bill within the same period and keeps 80 units. There are no other inventory changes, acquisition costs, discounts, returns or sales-related cash movements. Other company activities, operating expenses, financing and tax are outside this limited merchandise comparison.

Assign the costs under each rule

OpenStax's periodic inventory explanation compares different ways of assigning inventory costs. Use these two specified rules for the whole period:

Periodic FIFO (first in, first out): assign the earliest recorded costs first. The 120 units sold receive the opening 100 units' $10 cost, then another 20 units at $14: $1,000 plus $280 gives $1,280 of cost of goods sold. The remaining 80 units carry $14 each, or $1,120.

Periodic weighted average: pool the entire period's available cost and divide by all units available. The $1,000 opening cost plus the $1,400 purchase is $2,400 for 200 units, or $12 each. Assigning that average to 120 units gives $1,440 of cost of goods sold. The remaining 80 units carry $960.

Two periodic cost assignments for the same 120 units sold

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Both rules allocate the same $2,400 available cost: $1,280 plus $1,120, or $1,440 plus $960. FIFO leaves $160 more of that cost in ending inventory, so it recognizes $160 less in cost of goods sold and shows $160 more gross profit in this period.

FIFO gross profit is higher here because the older costs are lower. It has not made the new purchase cheaper. Nor does assigning the oldest costs prove which physical units the warehouse picked. These two presentations use the same shipment and the same 80 units left on hand.

Keep the payment record beside the cost rule

Both presentations have $2,400 collected and $1,400 paid for the current purchase: a $1,000 difference between these stated receipts and payments. The opening inventory's $1,000 was paid before the window. Recognizing inventory cost in this period is not another supplier payment.

That $1,000 difference is not a closing bank balance or the company's complete cash flow. The gross-profit figures also leave the company's other expenses outside the comparison. The inventory costs do not establish what a buyer would pay for the remaining units.

Repair the report

Rewrite this statement: “FIFO left us with $160 more cash and stock worth $1,120.” A supported version is: “FIFO assigns $160 more of the same available cost to the 80 unsold units. Its cost of goods sold is lower and its gross profit higher by $160. The physical stock and stated cash movements are unchanged.”

For the business decisions behind reported figures, find a starting point in Infinite Upside.