You buy inventory over time, not all at once (except, of course, when you first stock a store). How much you buy depends on customer demand and the amount of inventory you already own. Over time, the price you pay for inventory changes, both up and down. You need to select a method that best recognizes the cost of your inventory.
There are four methods: first-in, first-out; last-in, first-out; weighted average; and specific identification. After you understand and apply a method, you can attach an accurate cost to each inventory item. After you select a method, you need to stick with it, which is called the principle of consistency.
When you apply a consistent inventory cost method, your financials will be consistent. Someone reading your financial statements will see an apples-to-apples comparison of inventory costs. If you change from one method to another, you risk distorting your financial statements. At the least, you have to explain the change of method in the financials; it’s only fair to those reading the information, such as investors.
For this analysis, you should assume that prices increase over time. That’s normally what happens in real life. Inflation is defined as the overall increase in retail prices over time. Overall means the prices of a representative list of goods that people buy all the time, such as food, energy, medical services, and so forth. Those basic items are used to measure inflation. You can see a typical Consumer Price Index at the U.S. Bureau of Labor Statistics website.
The effect of prices increasing over time is that your older inventory costs less than your more recent purchases. You use this assumption for all three inventory methods.
Say you own a hardware store. This table displays purchase and sale dates, number of units, and prices for a rubber mallet.
| Date | Units Purchased | Price Per Unit | Total |
|---|---|---|---|
| 10/1 | 100 | $10 | $1,000 |
| 10/15 | 150 | $12 | $1,800 |
| 10/17 | 75 | $15 | $1,125 |
| Total Units | 325 | Total Cost | $3,925 |
| Date | Units Sold | ||
| 10/25 | 50 | ||
| 10/31 | 50 |
Here are a few keys things to remember for inventory costing:
The number of units purchased and sold is the same for all methods.
The units don’t change. Only the cost placed on the units changes.
The goods put on the shelf and then sold are the same in all cases.
There’s a total cost at the lower-right corner ($3,925). That total cost ends up in one of two places. You either sell the inventory (cost of sales), or it stays on the shelf (ending inventory).
The cost of sales and ending inventory adds up to $3,925. This is true, regardless of which inventory method you choose. If you remember to account for all the units — and all the dollars — you correctly account for inventory.