Page 283 - Accounting Principles (A Business Perspective)

7. Measuring and reporting inventories

Usually, inventory cost includes all the necessary outlays to obtain the goods, get the goods ready to sell, and
have the goods in the desired location for sale to customers. Thus, inventory cost includes:

• Seller's invoice price less any purchase discount.
• Cost of the buyer's insurance to cover the goods while in transit.
• Transportation charges when borne by the buyer.
• Handling costs, such as the cost of pressing clothes wrinkled during shipment.
In theory, the cost of each unit of inventory should include its net invoice price plus its share of other costs
incurred in shipment. The 1986 Tax Reform Act requires companies to assign these costs to inventory for tax
purposes. For accounting purposes, these cost assignments are recommended but not required.

Practical difficulties arise in allocating some of these costs to inventory items. Assume, for example, that the
freight bill on a shipment of clothes does not separate out the cost of shipping one shirt. Also, assume that the
company wants to include the freight cost as part of the inventory cost of the shirt. Then, the freight cost would
have to be allocated to each unit because it cannot be measured directly. In practice, allocations of freight,
insurance, and handling costs to the individual units of inventory purchased are often not worth the additional cost.
Consequently, in the past many companies have not assigned the costs of freight, insurance, and handling to
inventory. Instead, they have expensed these costs as incurred. When companies omit these costs from both
beginning and ending inventories, they minimize the effect of expensing these costs on net income. The required
allocation for tax purposes has probably resulted in many companies using the same inventory amounts in their

financial statements.
Even if a company derives a cost for each unit in inventory, the inventory valuation problem is not solved.
Management must consider two other aspects of the problem:
• If goods were purchased at varying unit costs, how should the cost of goods available for sale be allocated
between the units sold and those that remain in inventory? For example, assume Hi-Fi Buys, Inc.,
purchased two identical DVD players for resale. One cost USD 250 and the other, USD 200. If one was sold
during the period, should Hi-Fi Buys assign it a cost of USD 250, USD 200, or an average cost of USD 225?

• Does the fact that current replacement costs are less than the costs of some units in inventory have any
bearing on the amount at which inventory should be carried? Using the same example, if Hi-Fi Buys can
currently buy all DVD players for USD 200, is it reasonable to carry some units in inventory at USD 250
rather than USD 200?
We answer these questions in the next section.
Generally companies should account for inventories at historical cost; that is, the cost at which the items were
purchased. However, this rule does not indicate how to assign costs to ending inventory and to cost of goods sold
when the goods have been purchased at different unit costs. For example, suppose a retailer has three shirts on
hand. One costs USD 20; another, USD 22; and a third, USD 24. If the retailer sells two shirts for USD 30 each,

what is the cost of the two shirts sold?
Accountants developed these four inventory costing methods to solve costing problems: (1) specific
identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Before explaining
the inventory costing methods, we briefly introduce perpetual inventory procedure and compare periodic and
perpetual inventory procedures.

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