Inventories or Stocks – Part 3, Cost Formula

In Example 1 of my previous post, Inventories or Stocks – Part 2, Methods of Recording in General Ledger, the cost of purchasing inventories had been fixed in order to show the effect of two different methods of recording in General Ledger clearly. In reality, cost of inventory purchases fluctuates from time to time. Let’s explore the common ways of calculating the cost of inventories when purchase price fluctuates from time to time – This is called the Cost Formula of inventories. There are three common Cost Formulas for inventories: –

  1. FIFO (First-in-first-out)
  2. Weighted Average
  3. LIFO (Last-in-last-out)

Please take note of the difference between Cost Formulas (FIFO, Weighted Average or LIFO) and the methods of recording inventories in General Ledger (Periodic Method or Perpetual Method). A business entity could choose a combination of the following in recording its inventories: –

Methods of recording in General Ledger

Cost Formula

Combination 1

Periodic

FIFO

Combination 2

Periodic

Weighted Average

Combination 3

Periodic

LIFO

Combination 4

Perpetual

FIFO

Combination 5

Perpetual

Weighted Average

Combination 6

Perpetual

LIFO

As you can see from the above table, the choice of cost formula to be used is independent of how an entity chooses the method of recording inventories in the General Ledger.

Referring to the transactions ABC Co. Ltd. in Example 1 of my previous post, assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

  1. Inventories or stocks on hand as at 31 December 2005 comprised the following:-

    Quantity

    Unit Cost

    Total

    $

    $

    Stock Type A

    100

    5

    500

    Stock Type B

    200

    7

    1,400

    Stock Type C

    250

    20

    5,000

    6,900

  1. 15 January 2006

    Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

  2. 20 January 2006

    Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

  3. 21 March 2006

    Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

  4. 31 July 2006

    Purchase of 50 units of Type A stock at $6 each, on credit. Total purchases were $300.

  5. 30 September 2006

    Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

  6. 30 November 2006

    Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1

Stock Type A

Stock Type B

Stock Type C

Quantity

Quantity

Quantity

Balance as at

1 January 2006

100

200

250

Stock in:
20 January 2006

100

31 March 2006

50

Stock out:
15 January 2006

(50)

21 March 2006

(300)

30 September 2006

(75)

30 November 2006

(150)

Balance as at

31 December 2006

25

100

You would notice that all the above transactions are exactly the same as shown in Example 1 of my previous post except for Transaction e. The purchase cost of Stock A was $6 per unit instead of $5. The difference in this purchase cost requires certain cost formula to determine value of the inventories in hand as at 31 December 2006 and also to determine the cost of goods sold or cost of sales of 75 units of Stock A sold on 30 September 2007. Please take note that the cost of goods sold for the 50 units of Stock A sold on 15 January 2006 makes no difference in terms of the difference cost formula used because the cost per unit of Stock A prior to the sale of this 50 units of Stock A was $5 per unit (assuming the 100 units of Stock A in hand prior to this sale is from the same batch of purchase). The cost of sale and the unit cost of Stock A during the financial year ended 31 December are shown calculated under the three different cost formulas are below: –

FIFO (first-in-first-out)

Under the FIFO cost formula, the earliest batch of inventories would be given the priority over the subsequent batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 2

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 1

Stock out:
30 September 2006

(50)

(25)

(5)

(6)

*(250)

*(150)

Note 2

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

6

150

Note 3

Note 1: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $5 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 2: Under FIFO cost formula, the earliest batch of stock in hand i.e. the 50 units of Stock A @ $5 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand was therefore 25 units of Stock A @ $6.

Note 3: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006.

*: The total of $650 ($250 + $250 + $150) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006.

Weighted Average

Under the Weighted Average cost formula, the weighted average cost of all existing inventories on hand plus the new purchases is calculated and allocated to all inventories on hand (both old and new batch of purchases) with the same weighted average cost calculated. Table 3 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 3

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

100

5.5

550

Note 4

Stock out:
30 September 2006

(75)

(5.5)

*(412.5)

Note 5

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5.5

137.5

Note 6

Note 4: The weighted average cost of $5.5 was calculated by taking the total of the old batch of Stock A (50 x $5 = $250) plus the total of the new batch of Stock A purchased (50 x $6 = $300), divided by the total quantity of new and old stocks – {$250 + $300}/{50units + 50Units} = $5.5.

Note 5: Once the weighted average cost of $5.5 has been determined, the calculation of the cost of goods sold for this 75 units of Stock A is straight forward – 75 units x $5.5

Note 6: The calculation of closing inventories in hand is also straight forward – 25 units x $5.5

*: The total of $662.5 ($250 + $412.5) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

LIFO (last-in-first-out)

Under the LIFO cost formula, the latest batch of inventories would be given the priority over the earlier batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 4

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 7

Stock out:
30 September 2006

(50)

(25)

(6)

(5)

*(300)

*(125)

Note 8

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5

125

Note 9

Note 7: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $6 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 8: Under LIFO cost formula, the latest batch of stock in hand i.e. the 50 units of Stock A @ $6 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand due for stock out was therefore 25 units @ $5 from the earlier batch of Stock A.

Note 9: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006

*: The total of $675 ($250 + $300 + $120) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

The double entries for recording inventories under both the Periodic and Perpetual methods had been shown in my previous post. Of course the figures for Stock A are different from those shown in Example 1 of my previous post, depending on which cost formula is chosen. Figures for Stock B and Stock C remained the same.

Did you notice that the three cost formulas shown above give different cost of goods sold and also different inventory value at the end of the financial year?

Another point to note is that LIFO cost formula is prohibited in some countries.

Inventories or Stocks – Part 2, Methods of Recording in General Ledger

There are two common methods of recording inventories or stocks in the General Ledger of business entities:-

1. The Periodic Method

2. The Perpetual Method

The choice of the method used will directly determine the double entries for the recording of inventories or stocks of the entity concerned.

1. The Periodic Method

Under this method, the inventories or stocks account in the General Ledger would not be updated regularly with the movement of inventories or stocks throughout the whole financial period until the last closing day of the financial period in which the new inventories balance would be determined and adjusted accordingly. The balance of the inventories or stocks account remained at the amount brought forward from the previous financial period i.e. the opening inventories or stocks for the current financial period (this is also the closing balance of inventories or stocks for the previous financial period). At the end of the current financial period, an inventories counting exercise would be conducted to determine the closing balance of inventories and once this is done, the inventories or stocks account in the General Ledger would then be adjusted to reflect the correct inventories or stocks balance on the closing date. On the closing date (i.e. the end of the current financial period), the cost of goods sold would also be determined and deducted against the sales or turnover figure recorded for the current financial period to get the gross profit amount. The steps involved are explained in the following illustration:-

Example 1

Assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

a. Inventories or stocks on hand as at 31 December 2005 comprised the following: –

Quantity

Unit Cost

Total

$

$

Stock Type A

100

5

500

Stock Type B

200

7

1,400

Stock Type C

250

20

5,000

6,900

b. 15 January 2006

Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

c. 20 January 2006

Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

d. 21 March 2006

Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

e. 31 July 2006

Purchase of 50 units of Type A stock at $5 each, on credit. Total purchases were $250.

f. 30 September 2006

Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

g. 30 November 2006

Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The double entries for the above transactions are: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Trade debtors

400

Sales

400

(Sales for January 2006)

c. 20 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Purchases

700

Trade creditors

700

(Purchases for January 2006)

d. 21 March 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 March 2006

Trade debtors

3,000

Sales

3,000

(Sales for March 2006)

e. 31 July 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 July 2006

Purchases

250

Trade creditors

250

(Purchases for July 2006)

f. 30 September 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 September 2006

Trade debtors

675

Sales

675

(Sales for September 2006)

g. 30 November 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 November 2006

Trade debtors

3,750

Sales

3,750

(Sales for November 2006)

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1

Stock Type A

Stock Type B

Stock Type C

Quantity

Quantity

Quantity

Balance as at 1 January 2006

100

200

250

Stock in:
20 January 2006

100

31 March 2006

50

Stock out:
15 January 2006

(50)

21 March 2006

(300)

30 September 2006

(75)

30 November 2006

(150)

Balance as at 31 December 2006

25

100

The amount of inventories as at year end i.e. 31 December 2006 was $2,125, comprising 25 units of Type A stock valued at $5 each (Total of Type A stock = $125) plus 100 units of Type C stock valued at $20 each (Total of Type C stock = $2,000).

Note: In this example, the cost of purchases of inventories during the year was intentionally fixed to remain the same as those as at 1 January 2006 for the purpose of simplifying the illustration of this topic. For Type A stock, the purchase of inventories made on 31 March 2006 was at $5 each, the same cost as at 1 January 2006. Similarly, for Type B stock, the purchase cost was $7. In reality, this may not necessary be the case as the price of goods do fluctuate from time to time. In Part 3, the methods commonly used by business entities to determine the unit costs of inventories will be discussed.

Once the closing inventories balance as at 31 December 2006 is determined, the following journal entries would be made to reflect the correct inventories balance: –

Balance Sheet

Income Statement

DR

CR

DR

CR

31 December 2006

Cost of goods sold

6,900

Inventories

6,900

(Being transfer of opening inventories to cost of goods sold account)

31 December 2006

Inventories

2,125

Cost of goods sold

2,125

(Being recognition of closing inventories)

The relevant accounts in the General Ledger of ABC Co. Ltd are as follows: –

ABC Co. Ltd

Page 10

General Ledger

Inventories

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
01-Jan Balance B/F

6,900.00

31-Dec Cost of goods sold GL45

6,900.00

31-Dec Cost of goods sold GL45

2,125.00

31-Dec Balance C/F

2,125.00

9,025.00

9,025.00

ABC Co. Ltd

General Ledger

Trade Debtors

Page 15

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Sales GL30

400.00

31-Dec Balance C/F

7,825.00

31-Mar Sales GL30

3,000.00

30-Sep Sales GL30

675.00

30-Nov Sales GL30

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Trade Creditors

Page 20

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Balance C/F

950.00

31-Jan Purchases GL40

700.00

31-Jul Purchases GL40

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Sales

Page 30

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Transfer to Income statement

7,825.00

31-Jan Trade debtors GL15

400.00

31-Mar Trade debtors GL15

3,000.00

30-Sep Trade debtors GL15

675.00

30-Nov Trade debtors GL15

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Purchases

Page 40

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Purchases GL20

700.00

31-Dec Cost of goods sold GL45

950.00

31-Jul Purchases GL20

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Cost of Goods Sold

Page 45

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Inventories GL10

6,900.00

31-Dec Inventories GL10

2,125.00

31-Dec Purchases GL40

950.00

31-Dec Transfer to Income Statement

5,725.00

7,850.00

7,850.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd
Extract of Income Statement for the Year Ended 31 December 2006
Ref

$

Sales GL30

7,825.00

A

Cost of Goods Sold or Cost of Sales:
Opening Inventories GL45

– 6,900.00

B

Purchases GL45

– 950.00

C

Closing Inventories GL45

2,125.00

D

– 5,725.00

E = B+C-D

Gross Profit

2,100.00

F = A+E

An important point to note is for the Periodic Method of recording inventories or stocks, the Cost of Goods Sold or Cost of Sales has three components i.e. the opening inventories, the purchases during the year and also the closing inventories. This is also the formula of Cost of Goods Sold or Cost of Sales: –

Cost of Goods Sold/Cost of Sales = Opening Inventories + Purchases – Closing Inventories

Refer to Table 1, you could actually calculate the Cost of Goods Sold or Cost of Sales by multiplying the Quantity of Stock Out with the respective unit cost of the inventories as follows:-

Table 2

Stock Type A

Stock Type B

Stock Type C

Grand Total

A

B

C = A x B

D

E

F = D x E

G

H

I = G x H

J = C + F + I

Qty

Unit Cost

Total

Qty

Unit Cost

Total

Qty

Unit Cost

Total

$

$

$

$

$

$

$

Stock out:
15.1.06

-50

5.00

-250.00

-250.00

21.3.06

-300

7.00

-2,100.00

-2,100.00

30.9.06

-75

5.00

-375.00

-375.00

30.11.06

-150

20.00

-3,000.00

-3,000.00

TOTAL

-625.00

-2,100.00

-3,000.00

-5,725.00

2. The Perpetual Method

Under the Perpetual Method of recording inventories, the movement of inventories during the financial period is updated regularly to the inventories account in the General Ledger. As a result of this kind of regular updates, more time and effort is required if compared with the Period Method of recording inventories. Refer to the same transactions shown in Example 1, the journal entries required using the Perpetual method of recording inventories are as follows: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006
Trade debtors

400

Sales

400

(Sales for January 2006)
Cost of goods sold

250

Inventories

250

(Being cost of goods sold for January 2006)

c. 20 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Inventories

700

Trade creditors

700

(Purchases for January 2006)

d. 21 March 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 March 2006
Trade debtors

3,000

Sales

3,000

(Sales for March 2006)
Cost of goods sold

2,100

Inventories

2,100

(Being cost of goods sold for March 2006)

e. 31 July 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 July 2006

Inventories

250

Trade creditors

250

(Purchases for July 2006)

f. 30 September 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 September 2006
Trade debtors

675

Sales

675

(Sales for September 2006)
Cost of goods sold

375

Inventories

375

(Being cost of goods sold for September 2006)

g. 30 November 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 November 2006

Trade debtors

3,750

Sales

3,750

(Sales for November 2006)

Cost of goods sold

3,000

Inventories

3,000

(Being cost of goods sold for November 2006)

If you compare the above journal entries with those under the Periodic Method, the difference is for each sale transaction, the cost of goods sold or cost of sales must also be determined and recorded accordingly. This means, a systematic tracking method of the cost of inventories such as shown in Table 2 must be in place to facilitate monitoring the movement of inventories cost. In addition, the journal entries for transferring opening and closing inventories balances to the Cost of Goods Sold account as in the Periodic Method are not required. You would also notice that when ABC Co. Ltd made purchases of inventories, it was the Inventories account that was debited instead of the Purchases account under the Periodic Method. Should there be no incidence of inventories loss due to pilferage etc., the inventories account balance in the General Ledger would reflect the correct balance of closing inventories. The explanation on how stock losses are recorded and reflected will be done in other posts later. The obvious advantage of having a Perpetual Method of recording inventories over the Periodic Method is that those business entities using Perpetual Method are able to know the inventories balance at any point in time.

The relevant accounts in the General Ledger using Perpetual method of recording inventories are as follows: –

ABC Co. Ltd

Page 10

General Ledger

Inventories

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
01-Jan Balance B/F

6,900.00

31-Jan Cost of goods sold GL45

250.00

31-Jan Trade creditors GL20

700.00

31-Mar Cost of goods sold GL45

2,100.00

31-Jul Trade creditors GL20

250.00

30-Sep Cost of goods sold GL45

375.00

30-Nov Cost of goods sold GL45

3,000.00

31-Dec Balance C/F

2,125.00

7,850.00

7,850.00

ABC Co. Ltd

General Ledger

Trade Debtors

Page 15

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Sales GL30

400.00

31-Dec Balance C/F

7,825.00

31-Mar Sales GL30

3,000.00

30-Sep Sales GL30

675.00

30-Nov Sales GL30

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Trade Creditors

Page 20

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Balance C/F

950.00

31-Jan Inventories GL10

700.00

31-Jul Inventories GL10

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Sales

Page 30

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Transfer to Income Statement

7,825.00

31-Jan Trade debtors GL15

400.00

31-Mar Trade debtors GL15

3,000.00

30-Sep Trade debtors GL15

675.00

30-Nov Trade debtors GL15

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Cost of Goods Sold

Page 45

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Inventories GL10

250.00

31-Dec Transfer to Income Statement

5,725.00

31-Mar Inventories GL10

2,100.00

30-Sep Inventories GL10

375.00

30-Nov Inventories GL10

3,000.00

5,725.00

5,725.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd

Extract of Income Statement for the Year Ended 31 December 2006

Ref

$

Sales GL30

7,825.00

A

Cost of Goods Sold or Cost of Sales: GL45

– 5,725.00

B

Gross Profit

2,100.00

C = A + B

As you can see, there is no purchases account created under the Perpetual Method.