Cost formulas

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using

a. First in, First out

b. Weighted average

The standard does not permit anymore the use of the last in, first out (LIFO) as an alternative formula in
measuring cost of inventories.

First in, First out (FIFO)

The FIFO method assumes that "the goods first purchased are first sold" and consequently the goods
remaining in the inventory at the end of the period are those most recently purchased or produced.

In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods
are sold in the order they are purchased.

The rule is "first come, first sold".

The inventory is thus expressed in terms of recent or new prices while the cost of goods sold is
representative of earlier or old prices.

This method favors the statement of financial position in that the inventory is stated at current
replacement cost. The objection to the method is that there is improper matching of cost against
revenue because the goods sold are stated at earlier or older prices resulting in understatement of cost
of sales.

Accordingly, in a period of inflation or rising prices, the FIFO method would result to the highest net
income.
SP- @P3
200,000@2=400,000
100,000@1=100,000
300,000 500,000
Unit cost WA= 500,000/300,000=1.67

However, in a period of deflation or declining prices, the FIFO method would result to the lowest net
income.
SP- @P.25
200,000@2=400,000
100,000@1=100,000
300,000 500,000

Illustration – FIFO

The following data pertain to an inventory item:

Units Unit cost Total cost Sales (in units)

Jan. 1 Beginning balance 800 200 160,000
8 Sale 500
18 Purchase 700 210 147,000
 22 Sale 800
31 Purchase 500 220 110,000

The ending inventory is 700 units.

FIFO – Periodic

Units Unit cost Total cost

From Jan. 18 Purchase 200 210 42,000
From Jan. 31 Purchase 500 220 110,000
700 152,000

Cost of goods sold

Inventory - January 1 160,000

Purchases (147,000 + 110,000) 257,000
Goods available for sale 417,000
Inventory - January 31 (152,000)
Cost of goods sold 265,000

FIFO – Perpetual

This requires preparation of stock card.

Purchases Sales Balance

Date Units Unit cost Total cost Units Unit cost Total cost Units Unit cost Total cost
Jan 1 800 200 160,000
8 500 200 100,000 300 200 60,000
18 700 210 147,000 300 200 60,000
700 210 147,000
22 300 200 60,000
500 210 105,000 200 210 42,000
31 500 220 110,000 200 210 42,000
500 220 110,000

NOTA BENE

Note well that under FIFO-periodic and FIFO-perpetual, the inventory costs are the same. In both cases,
the January 31, inventory is P152,000.

The cost of goods sold is determined for the stock card as follows:

January 8 sale 100,000

22 sale (60,000 + 105,000) 165,000
Cost of goods sold 265,000

Weighted average – Periodic

The cost of the beginning inventory plus the total cost of purchases during the period is divided by the
total units purchased plus those in the beginning inventory to get a weighted average unit cost.

Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value.

In other word, the average unit cost is computed by dividing the total cost of goods available for sale
by the total number of units available for sale.

The preceding illustrative data are used.

Units Unit cost Total cost

Jan 1 Beginning balance 800 200 160,000
18 Purchase 700 210 147,000
31 Purchase 500 220 110,000
Total goods available for sale 2,000 417,000

Weighted average unit cost (417,000/2,000) 208.50

Inventory cost (700 x 208.50) 149,950

Cost of goods sold

Inventory - January 1 160,000

Purchases (147,000 + 110,000) 257,000
Goods available for sale 417,000
Inventory - January 31 (149,950)
Cost of goods sold 271,050

OR
1,300x208.5=271,050

Weighted average – Perpetual

When used in conjunction with the perpetual system, the weighted average method is popularly known
as the moving average method.

PAS 2, paragraph 27, provides that the weighted average may be calculated on a periodic basis or as
each additional shipment is received depending upon the circumstances of the entity.

Under this method, a new weighted average unit cost must be computed after every purchase and
purchase returns.

Thus, the total cost of goods available after every purchase and purchase return is divided by the total
units available for sale at this time to get a new weighted average unit cost.

Such new weighted average unit cost is then multiplied by the units on hand to get the inventory cost.

This method required the keeping of stock card in order to monitor the “moving” unit cost after every
purchase.
 Units Unit cost Total cost
Jan 1 Beginning balance 800 200 160,000
8 Sale (500) 200 (100,000)
Balance 300 200 60,000
18 Purchase 700 210 147,000
Total 1,000 207 207,000
22 Sale (800) 207 (165,600)
Balance 200 207 41,400
31 Purchase 500 220 110,000
Total 700 216 151,400

Observe that a new weighted average unit cost is computed after every purchase.

Thus, after the January 18 purchase, the total cost of P207,000 is divided by 1,000 units to get a weighted
average unit cost of P207.

After the January 31 purchase, the total cost of P151,400 is divided by 700 units to get a new weighted
average unit cost of P216.

Cost of goods sold from the stock card

January 8 Sale 100,000

22 Sale 165,600
Cost of goods sold 265,600

The argument for the weighted average method is that it is relatively easy to apply, especially with
computers. Moreover. The weighted average method produces inventory valuation that approximates
current value if there is a rapid turnover of inventory.

The argument against the weighted average method is that there may be a considerable lag between
the current cost and inventory valuation since the average unit cost involves early purchases.

Last in, Fist out (LIFO)

The LIFO method assumes that “the good last purchased are first sold” and consequently the goods
remaining in the inventory at the end of the period are those first purchased or produced.

The inventory is thus expressed in terms of earlier or old prices and the cost of goods sold is representative
of recent or new prices.

The LIFO favors the income statement because there is matching of current cost against current
revenue, the cost of goods sold being expressed in terms of current or recent cost.

The objection of the LIFO is that the inventory is stated at earlier or older prices and therefore there may
be a significant lag between inventory valuation and current replacement cost.
Moreover, the use of LIFO permits income manipulation, such as by making year-end purchases
designed to preserve existing inventory layers. At times these purchases may not even be in the best
economic interest of the entity.

Actually, in a period of rising prices, the LIFO method would result to the lowest net income. In a period
of declining prices, the LIFO method would result to the highest net income.

LIFO – Periodic

In the preceding illustration, the cost of 700 units under the LIFO is computed as follows.

Units Unit cost Total cost

From January 1 balance 700 200 140,000

Cost of goods sold under LIFO – periodic

Inventory - January 1 160,000

Purchases (147,000 + 110,000) 257,000
Goods available for sale 417,000
Inventory - January 31 (140,000)
Cost of goods sold 277,000

LIFO – Perpetual

This requires the preparation of stock card.

Purchases Sales Balance

Date Units Unit cost Total cost Units Unit cost Total cost Units Unit cost Total cost
Jan 1 800 200 160,000
8 500 200 100,000 300 200 60,000
18 700 210 147,000 300 200 60,000
700 210 147,000
22 700 210 147,000
100 200 20,000 200 200 40,000
31 500 220 110,000 200 220 40,000
500 220 110,000
Note well the LIFO-periodic and LIFO-perpetual differ in inventory value.

Under LIFO periodic, the January 31 inventory is P140,000 and under LIFO perpetual, the January 31
inventory is P150,000.

Another illustration

Units Unit cost Total cost

Jan. 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
15 Sale (7,000)
16 Sale return 1,000
30 Purchase 16,000 150 2,400,000
 31 Purchase return (2,000) 150 300,000
Ending balance 18,000

FIFO – whether periodic or perpetual

Units Unit cost Total cost

Jan 10 Purchase 4,000 250 1,000,000
30 Purchase 14,000 150 2,100,000
18,000 3,100,000
Specific Identification

The January 30 purchase of 16,000 units is reduced by the purchase return of 2,000 units or net purchase
of 14,000 units. Note that under FIFO perpetual, the sale return of 1,000 units on January 16 would be
costed back to inventory at the latest purchase unit cost of P250 before the sale.

Moving average – Perpetual

Units Unit cost Total cost

Jan 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
Balance 10,000 225 2,250,000
15 Sale (7,000) 225 (1,575,000)
Balance 3,000 225 675,000
16 Sale return 1,000 225 225,000
Balance 4,000 225 900,000
30 Purchase 16,000 150 2,400,000
Balance 20,000 165 3,300,000
31 Purchase return (2,000) 150 (300,000)
Balance 18,000 167 3,000,000

Units Unit cost Total cost

Jan 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
Balance 10,000 225 2,250,000
15 Sale (7,000) 225 (1,575,000)
Balance 3,000 225 675,000
15 Purchase 5,000 260 1,300,000
Balance 8,000 247 1,975,000
16 Sale return 1,000 225 225,000
Balance 9,000 225 900,000
30 Purchase 16,000 150 2,400,000
Balance 20,000 165 3,300,000
31 Purchase return (2,000) 150 (300,000)
Balance 18,000 167 3,000,000

Observe that the moving average unit cost changes every time there is a new purchase or a purchase
return. The moving average unit cost is not affected by a sale or a sale return.

Weighted average – Periodic

 Units Unit cost Total cost
Jan 1 Beginning balance 5,000 200 1,000,000
10 Purchase 5,000 250 1,250,000
30 Purchase 16,000 150 2,400,000
31 Purchase return (2,000) 150 (300,000)
24,000 4,350,000

Weighted average unit cost (P4,350,000/24,000 units) 181.25

Cost of ending inventory (18,000 x 181.25) 3,262,500

Specific identification

Specific identification means that specific costs are attributed to identified items of inventory.

The cost of the inventory is determined by simply multiplying the units on hand by their actual unit cost.

This requires records which will clearly determine the actual costs of the goods on hand.

PAS 2, paragraph 23, provides that this method is appropriate for inventories that are segregated for a
specific project and inventories that are not ordinarily interchangeable.

The major argument for this method is that the flow of the inventory cost corresponds with the actual
physical flow of goods.

With specific identification, there is an actual determination of cost of units sold and on hand.

The major argument against this method is that it is very costly to implement even with high-speed
computers.

Standard costs

Standard costs are predetermined product costs established on the basis of normal levels of materials
and supplies, labor, efficiency and capacity utilization.

Observe that a standard cost is predetermined and, once determined, is applied to all inventory
movements – inventories, goods available for sale, purchases and goods sold or placed in production.

PAS 2, paragraph 21, states that the standard cost method may be used for convenience if the results
approximate cost.

However, the standards set should be realistically attainable and are reviewed and revised regularly in
the light of current conditions.

Standard costing is taken up in higher accounting course and is not discussed further in this book.

Relative sales price method

When different commodities are purchased at a lump sum, the single cost is apportioned among the
commodities based on their respective sales price. This is based on the philosophy that cost is
proportionate to selling price.

For example, products A, B, and C are purchased at “basket price” of P3,000,000. Assume that the said
products have the following sales price: A P500,000, B P1,500,000, and C P3,000,000.

Computation of cost of each product

Product A 500,000 5/50 x 3,000,000 300,000

Product B 1,500,000 15/50 x 3,000,000 900,000
Product C 3,000,000 30/50 x 3,000,000 1,800,000
5,000,000 3,000,000

References
Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 1. GIC Enterprises and Co., Inc. Manila,
Philippines

Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila,
Philippines

Valix, C. Valix, C.A. (2019). Intermediate Accounting 1. GIC Enterprises and Co., Inc. Manila,
Philippines

Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc.,
Mandaluyong City

Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines