In this video, we walk through 5 FAR practice questions teaching about calculating COGS using different costing methods. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating COGS Using Different Costing Methods
Understanding how to calculate Cost of Goods Sold (COGS) using various inventory costing methods is crucial for financial professionals, business owners, and accounting students. The method used can significantly impact a company’s reported profits, tax liabilities, and financial statements. In this post, we’ll break down some of the primary methods—LIFO (Periodic), Weighted Average, and Moving Average, along with an explanation of how LIFO and FIFO behave differently in changing economic conditions.
Calculating COGS Using Periodic LIFO
LIFO (Last-In, First-Out) assumes that the most recently purchased or produced goods are sold first. Under periodic LIFO, the COGS is calculated at the end of the accounting period using the most recent inventory costs.
Example:
Imagine a company that has the following inventory transactions during the year:
- Beginning Inventory: 100 units @ $10 each
- Purchase 1: 200 units @ $12 each
- Purchase 2: 150 units @ $15 each
- Total units sold: 300 units
To calculate COGS using periodic LIFO:
The company will use the costs of the most recent purchases first:
150 units @ $15 = $2,250
150 units @ $12 = $1,800
Total COGS = $2,250 + $1,800 = $4,050
The remaining units (100 units @ $10 each) are left in ending inventory.
Calculating COGS Using the Weighted Average Method
The Weighted Average Method averages out the cost of all units available for sale during the period. It assigns the same cost per unit to all goods, whether they were produced or purchased at different times.
Example:
Suppose a company has the following transactions:
- Beginning Inventory: 100 units @ $10 each
- Purchase 1: 200 units @ $15 each
- Purchase 2: 150 units @ $20 each
- Total units sold: 300 units
To find COGS:
- Calculate Total Units and Cost:
Total units = 100 + 200 + 150 = 450 units
Total cost = $1,000 + $3,000 + $3,000 = $7,000 - Calculate Weighted Average Cost per Unit:
Weighted Average Cost = $7,000 / 450 units = $15.56 per unit - Calculate COGS:
300 units × $15.56 = $4,668
This method smooths out price fluctuations and is commonly used when the inventory items are indistinguishable or when it’s impractical to track costs for individual items.
Calculating COGS Using the Moving Average Method
The Moving Average Method is similar to the weighted average but recalculates the average cost per unit after every purchase. It is used in perpetual inventory systems, where each purchase updates the average unit cost.
Example:
Suppose a company begins the period with 50 units @ $8 each and has the following transactions:
- Purchase 1: 100 units @ $10 each
- Sale 1: 80 units
- Purchase 2: 50 units @ $12 each
- Sale 2: 50 units
To calculate COGS using the moving average method:
Initial Average Cost = $8.00 per unit
After Purchase 1:
New Average Cost = ($8 × 50 + $10 × 100) / 150 = $9.33 per unit
COGS for Sale 1:
80 units @ $9.33 = $746.40
After Purchase 2:
New Average Cost = ($9.33 × 70 + $12 × 50) / 120 = $10.50 per unit
COGS for Sale 2:
50 units @ $10.50 = $525
The moving average method adjusts the cost basis with each purchase, making it ideal for inventory items with regular price changes.
Calculating COGS from Manufacturing Costs
For manufacturing companies, COGS includes all costs directly related to producing goods, such as direct materials, direct labor, and manufacturing overhead. However, it’s essential to distinguish these costs from period costs like administrative and selling expenses.
Example:
Brightwood Furniture incurred the following expenses:
- Direct materials: $50,000
- Direct labor: $30,000
- Factory rent: $10,000
- Office salaries: $5,000
- Sales commissions: $3,000
- Ending materials: $10,000
Calculate COGS:
Direct materials used = $50,000 (beginning) – $10,000 (ending) = $40,000
Total manufacturing costs = $40,000 + $30,000 + $10,000 = $80,000
COGS = $80,000
Office salaries and sales commissions are not included as they are period costs, not inventoriable costs.
LIFO vs. FIFO: COGS in Different Economic Conditions
The choice between LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) can significantly impact COGS and net income, depending on the economic environment.
Rising Prices (Inflationary Environment):
LIFO results in higher COGS because the latest (and more expensive) inventory costs are recorded as sold first. This results in lower net income and lower ending inventory values.
FIFO results in lower COGS because older, cheaper costs are used first. This leads to higher net income and higher ending inventory values.
Falling Prices (Deflationary Environment):
LIFO results in lower COGS as the recent, lower costs are matched with sales, leading to higher inventory and net income.
FIFO results in higher COGS due to using older, higher costs, which lowers inventory and net income.
Example:
A company with the following purchases experiences rising prices:
- Beginning Inventory: 100 units @ $10 each
- Purchase 1: 200 units @ $12 each
- Purchase 2: 150 units @ $15 each
- Total units sold: 300 units
LIFO COGS = 150 units @ $15 + 150 units @ $12 = $4,050
FIFO COGS = 100 units @ $10 + 200 units @ $12 = $3,400
The $650 difference shows how LIFO reports higher COGS in inflationary environments.