There are several inventory costing systems that companies can choose to help them when determining cost of goods sold and ending inventories, and each has its own advantages and disadvantages. When using the First-In-First-Out (FIFO) method, it is assumed that merchandise bought first will be sold first. The cost of goods sold is always recorded at the oldest available purchase costs and the remaining inventory is valued at the more recent purchase costs.
Last-In-First-Out (LIFO) is a method that assumes that the most recently purchased merchandise will be sold first. The most recent purchase costs are transferred to the costs of goods sold and the remaining inventory is valued at the oldest purchase costs. Since LIFO reports a higher cost of goods sold, it usually results in lower taxable income, which lowers the amount of taxes the company has to pay. If a company chooses to use this method when filing taxes, it must also use it in its financial statements. The downside of this is that “during periods of rising inventory replacement costs, the LIFO method results in the lowest valuation of inventory and measurement of net income.” (Williams, 2016)
The average cost method assumes all items in inventory have the same per-unit cost, which is determined by dividing the total cost of goods available for sale by the number of units in inventory.
The Lower-of-Cost-or-Market (LCM) Rule is a method of inventory pricing in which goods sold are valued at the lower of original cost or current replacement cost.
The FIFO method makes the most sense to me, not only for the tax benefits, but also because I relate it to my experience of using up products that were bought first, based on their shelf life, before the most-recently purchased products. I know that really only applies to food and other perishable goods, but it’s how I relate to it. I reviewed the 2015 Annual Report for Monsanto Company and was surprised to find in the financial statements’ notes that they use the FIFO method to determine the cost of Agricultural Productivity inventories housed outside of the US, and for supplies inventories in the US because the requirements in the companies where Monsanto holds its inventories generally do not allow the LIFO method to be used. The company uses the LIFO method to determine the cost of the company’s Agricultural Productivity segment inventories maintained in the US since LIFO generally reflects the effects of inflation or deflation cost of goods sold sooner than other inventory methods.
The Just-In-Time (JIT) inventory system mainly applies to manufacturers, but it can also apply to suppliers, assemblers, and distributors. Many manufacturers do not produce goods until they have a buyer for them, which helps reduce inventory and increase efficiency. For example, “Dell Corporation doesn’t start ordering components or assembling computers until an order has been booked.” (Williams, 2016) It surprises me that they can get their products out so fast using this system. I use them often and have received the products within a few days of ordering.
Activity Based Costing (ABC) is a cost accounting method that tracks indirect costs to the activities that use up the resources. First, overhead costs are categorized into a number of activity cost pools, which represent a type of overhead activity, such as building maintenance, purchasing materials, heating of the factory, and machinery repairs. Then, the overhead costs in each pool are applied to production separately. “ABC identifies and makes use of the most appropriate cost driver for applying each category of overhead costs.” (Williams, 2016, p 771-772) It is helpful to management as it provides information on the cost of different overhead activities. They could use the information to pinpoint activities that cost the most and see if there are ways to be more efficient and reduce these costs.
Tangible assets are those that have physical characteristics, including a company’s land, buildings and equipment. When land is being used for the removal or extraction of valuable natural resources, such as oil, minerals, or timber, it is not included as a tangible asset. Intangible assets are the rights and privileges that have been developed or acquired by a company, such as trade names, patents, copyrights, trademarks, and franchises. They have no physical substance, but are important to the operation of the business.
Intangible assets are not subject to depreciation. Some tangible assets, such as buildings and equipment, are subject to depreciation as they have a “limited useful life.” (Williams, 2016) Land is not depreciated as its existence and usefulness has no limit.
In relation to tangible and intangible assets, allocating “the cost of a plant asset includes all expenditures that are ‘reasonable and necessary’ and for getting the asset to the desired location and ‘ready for use.’” (Williams, 2016) The cost of the asset is included, as well as incidental costs such as sales taxes, delivery charges, and installation costs.
Capital expenditures are costs to purchase or expand plant assets, and that will benefit several accounting periods. Revenue expenditures are incurred for items necessary to the ownership and operation of a company’s plant and equipment, such as normal repairs, maintenance, and fuel, etc., and will be used up in the current accounting period. These expenditures are not material in cost.
Williams (2016) Financial & Managerial Accounting. McGraw-Hill Education.
Monsanto Annual Report. Retrieved July 29, 2016 from http://www.monsanto.com/investors/documents/annual%20report/2015/2015_annual_report_fullweb.pdf