Methods of Calculating the Cost of Inventory
We will explain three main methods of calculating cost of inventory: specific cost, FIFO (First in, First out) and AVCO (average cost).
Specific cost: When items of inventory are individually distinguishable and of high value, so we will use unit cost (actual cost or specific cost).
FIFO or AVCO (average cost) : Where inventories consist of a large number of interchangeable (ie identical or very similar) items, so we will use FIFO or AVCO (average cost). LIFO(last-in, first-out) is not allowed under International Financial Reporting Standard (IFRS).
FIFO- is a method of estimating cost which assumes that inventory is used or sold in the same order that it is purchased by the business.
AVCO (average cost)- method of estimating cost which assumes that all inventory purchased is mixed together. This assumption would be true for liquid inventory. There are two possible methods for AVCO (average cost):
- Continuous weighted average= (inventory value of items in stores + purchase cost of units received)/(Quantity already in stores + Quantity received)
- Periodic weighted average (simple weighted average)= ( cost of opening inventory + cost of all receipts in the period)/(units in opening inventory + units received)
Example:
ABC Company purchases and sells Phone Y
In November 1,000 units were purchased and 800 units sold as follows:
3 November 400 units purchased at $60 per unit
5 November 200 units sold
11 November 300 units at $70 per unit
14 November 200 units sold
21 November 300 units at $80 per unit
22 November 200 units sold
27 November 200 units sold
First In First Out (FIFO) Method:
| Date | Receipts | Sold | Balance | |
| No. of inventory | $ | |||
| 3 Nov | 400 x $60 | 400 | 24,000 | |
| 5 Nov | 200 x $60 | 200 | 12,000 | |
| 11 Nov | 300 x $70 | 500 | 33,000 | |
| 14 Nov | 200 x $60 | 300 | 21,000 | |
| 21 Nov | 300 x $80 | 600 | 45,000 | |
| 22 Nov | 200 x $70 | 400 | 31,000 | |
| 27 Nov | 100 x $70
100 x $80 |
200 | 16,000 | |
| Cost of sale is $53,000 and the value of closing inventory is $16,000. | ||||
Continuous Weighted Average Cost (AVCO) Method:
Weighted average cost is calculated each time that there is a new delivery into stores.
Weighted average price = (inventory value of items in stores + purchase cost of units received)/(Quantity already in stores + Quantity received)
| Date | Quantity | Purchase Price | Value | Weighted average price |
| $ | $ | $ | ||
| 3 Nov | 400 | 60 | 24,000 | 60 |
| 5 Nov | (200) | (12,000) | 60 | |
| 200 | 12,000 | 60 | ||
| 11 Nov | 300 | 70 | 21,000 | |
| Balance | 500 | 33,000 | 66 (33,000/500) | |
| 14 Nov | (200) | (13,200) | 66 | |
| 300 | 19,800 | 66 | ||
| 21 Nov | 300 | 80 | 24,000 | |
| Balance | 600 | 43,800 | 73(43,800/600) | |
| 22 Nov | (200) | (14,600) | 73 | |
| 27 Nov | (200) | (14,600) | 73 | |
| 30 Nov | 200 | 14,600 | 73 | |
| Cost of sale is $54,400 and the closing inventory is $14,600. | ||||
Periodic Weighted Average Cost Method:
Period weighted average price= ( cost of opening inventory + cost of all receipts in the period)/(units in opening inventory + units received)
Periodic weighted average price = (400×60+300×70+300×80)/(400+300+300)=$69 per unit.
Cost of sale = 800 units x 69$=$55,200
Inventory of end period = 200 units x 69$=$13,800