Inventory I: cost and cost formulas

Inventory is often a manufacturer's largest current asset, and it links the balance sheet to the income statement: every dollar of cost that is not in ending inventory becomes cost of sales. ACCT-101 introduced periodic and perpetual systems and the FIFO and weighted-average formulas. This lesson goes further. It asks which goods belong in inventory at all, which costs are capitalized into it (including the allocation of production overhead in a factory such as Northlake's), and how the permitted cost formulas work in perpetual and periodic systems. IAS 2, Inventories, governs IFRS reporters and ASPE Section 3031 private enterprises; the two are closely aligned. LIFO, still common in the United States, is prohibited under both, and this lesson explains why. Lesson 8 covers valuation at the lower of cost and net realizable value and estimation methods.

Which goods are included

Inventory includes goods the entity controls, whether or not they are physically on its premises. Three situations cause most errors at year end. Goods in transit belong to whoever holds legal title and control under the shipping terms: under FOB shipping point, title passes to the buyer when the goods leave the seller, so goods in transit at year end are the buyer's inventory; under FOB destination, title passes when the goods arrive, so they remain the seller's. Goods on consignment, placed with a dealer who sells them on the owner's behalf, remain the consignor's inventory until sold. And goods sold under a repurchase agreement or with a right of return remain in, or partly in, the seller's inventory (lesson 5 recorded an asset for goods expected to be returned).

Which costs are capitalized

The cost of inventory comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of purchase include the purchase price, import duties and non-recoverable taxes, transport and handling, less trade discounts and rebates. Recoverable sales taxes such as GST and HST, for which the business claims input tax credits, are excluded. Costs of conversion include direct labour and a systematic allocation of fixed and variable production overhead, such as factory depreciation, maintenance, utilities and supervision.

Fixed production overhead is allocated based on the normal capacity of the production facilities, the production expected on average over several periods under normal circumstances. If actual production is unusually low, unallocated fixed overhead is expensed in the period; it is not loaded onto fewer units, which would overstate their cost. If production is unusually high, the amount allocated per unit is reduced so that inventory is not carried above cost. Costs excluded from inventory and expensed as incurred include abnormal amounts of wasted materials, labour or other production costs; storage costs unless necessary in the production process (such as aging wine); administrative overheads that do not contribute to bringing inventory to its location and condition; and selling costs. Borrowing costs can be included only for inventories that take a substantial period to get ready for sale (IAS 23), which is rare.

# Allocating fixed production overhead at normal capacity (illustrative)
fixed_overhead = 2_400_000          # factory depreciation, supervision, etc.
normal_capacity_units = 8_000       # sensor stations a year on average
actual_units = 6_000                # a slow year
variable_cost_per_unit = 3_100      # materials, direct wages, variable overhead

rate = fixed_overhead / normal_capacity_units
allocated = rate * actual_units
unallocated = fixed_overhead - allocated
print(f"Fixed overhead rate per unit: {rate:,.0f}")
print(f"Allocated to inventory: {allocated:,.0f}; expensed as unallocated: {unallocated:,.0f}")
print(f"Cost per station: {variable_cost_per_unit + rate:,.0f}")
wrong = variable_cost_per_unit + fixed_overhead / actual_units
print(f"(If overhead were spread over actual units: {wrong:,.0f} per station, overstated)")

Fixed overhead rate per unit: 300
Allocated to inventory: 1,800,000; expensed as unallocated: 600,000
Cost per station: 3,400
(If overhead were spread over actual units: 3,500 per station, overstated)

In a slow year Northlake produces only 6,000 stations against normal capacity of 8,000. Fixed overhead is allocated at $300 per unit, so $1,800,000 goes into inventory and $600,000 of unabsorbed overhead is expensed immediately. Each station costs $3,400. Spreading the overhead over actual production would have produced a cost of $3,500 a station and pushed idle-capacity cost into inventory, inflating profit in the slow year and depressing it when the goods are sold.

Cost formulas

IAS 2 permits three cost formulas. Specific identification must be used for items that are not ordinarily interchangeable and for goods produced and segregated for specific projects, such as custom stations built for a particular airport. For other items, the entity uses first-in, first-out (FIFO) or weighted-average cost. The same formula must be used for all inventories of a similar nature and use; different formulas may be justified for inventories with a different nature or use, but not by location or tax considerations alone. ASPE Section 3031 has the same rules. LIFO (last-in, first-out) is prohibited because it does not faithfully represent the flow of inventory and can leave very old costs on the balance sheet.

Under FIFO, the earliest costs are assigned to cost of sales, so ending inventory reflects the most recent purchases. In a period of rising prices FIFO produces lower cost of sales, higher profit and an inventory balance close to current replacement cost. Under weighted average, an average cost per unit is computed, for the whole period in a periodic system, or after each purchase (a moving average) in a perpetual system, and applied to units sold and units on hand. Weighted average smooths price changes and gives results between FIFO and LIFO.

# FIFO, weighted average and LIFO for a sensor component (periodic system)
purchases = [("Opening", 400, 52.0), ("Feb", 600, 55.0), ("Jun", 800, 58.0), ("Oct", 500, 62.0)]
units_sold = 1_700
units = sum(q for _, q, _ in purchases)
cost = sum(q * c for _, q, c in purchases)
ending_units = units - units_sold

def layers_cost(layers, n):
    total, left = 0.0, n
    for _, q, c in layers:
        take = min(q, left); total += take * c; left -= take
        if left == 0: break
    return total

fifo_cogs = layers_cost(purchases, units_sold)
lifo_cogs = layers_cost(list(reversed(purchases)), units_sold)
avg = cost / units
methods = {"FIFO": fifo_cogs, "Weighted average": avg * units_sold, "LIFO": lifo_cogs}
print(f"Goods available: {units:,} units, cost {cost:,.0f}; ending {ending_units} units")
for name, cogs in methods.items():
    print(f"{name:<17} COGS {cogs:>9,.0f}  ending inventory {cost - cogs:>8,.0f}")
print(f"LIFO reserve (FIFO inventory - LIFO inventory): {(cost - fifo_cogs) - (cost - lifo_cogs):,.0f}")

Goods available: 2,300 units, cost 131,200; ending 600 units
FIFO              COGS    94,400  ending inventory   36,800
Weighted average  COGS    96,974  ending inventory   34,226
LIFO              COGS    99,400  ending inventory   31,800
LIFO reserve (FIFO inventory - LIFO inventory): 5,000

With prices rising from $52 to $62 a unit, FIFO gives the lowest cost of goods sold ($94,400) and highest ending inventory ($36,800); LIFO the highest cost of goods sold ($99,400) and lowest inventory ($31,800); weighted average falls between, at about $96,974 and $34,226. The $5,000 difference between FIFO and LIFO inventory is the LIFO reserve for this item. Total cost of goods available is the same under every method; the formula only decides how it is split between the income statement and the balance sheet.

Perpetual systems and the moving average

Most manufacturers and retailers today use perpetual systems, updating inventory and cost of sales with each transaction. Under FIFO, periodic and perpetual systems give the same results, because the oldest layers are used first either way. Under weighted average they differ: a perpetual moving average recomputes the unit cost after each purchase, so units sold early in the year carry the average at that time. Under LIFO, perpetual and periodic results also differ, because a perpetual LIFO assigns the latest costs at the time of each sale rather than at year end.

LIFO in the United States, for comparison

Canadian students often meet LIFO when analysing US competitors, so it is worth understanding. Under LIFO, the latest costs flow to cost of sales and the oldest remain in inventory. In rising prices LIFO lowers taxable income, which is why US companies use it: the US tax code permits LIFO for tax only if it is also used for financial reporting (the LIFO conformity rule). US companies using LIFO disclose a LIFO reserve, the difference between inventory at FIFO (or current cost) and at LIFO, so analysts can convert to FIFO for comparison with IFRS reporters: FIFO inventory = LIFO inventory + LIFO reserve, and FIFO cost of sales = LIFO cost of sales − increase in the LIFO reserve during the year. When a LIFO company sells more units than it buys, old low-cost layers are liquidated, cost of sales falls and profit rises, a LIFO liquidation that can flatter results in a bad year.

Because tracking individual layers for thousands of items is impractical, US companies typically use dollar-value LIFO, which groups items into pools and measures layers in dollars at base-year prices using a price index. Ending inventory at base-year prices is compared with the prior year; an increase is a new layer, valued at the current year's index. The method is more complex than this course needs, but its purpose is simple: to keep LIFO's tax benefit while allowing the product mix within a pool to change.

Choosing and changing formulas

The choice of formula affects reported profit, taxes (where tax follows the books), ratios and comparability. In Canada, the Income Tax Act allows FIFO, average cost and specific identification but not LIFO for tax purposes, so a Canadian company gains no tax benefit from any particular formula beyond timing differences. A change in cost formula is a change in accounting policy, applied retrospectively with restated comparatives, and must be justified as giving more reliable and relevant information. A change in the estimate of normal capacity, by contrast, is applied prospectively.