Lesson Objectives:- The three types of inventory costing methods
- Importance of calculating cost of goods sold
- Definition of specific identification
- How COGS is calculated using this method.
We've looked at how to journalize different types of transactions for both the perpetual and periodic inventory systems. Now we will dig into how to calculate the cost of goods sold figure that is listed on the income statement.
In some of the previous examples, I've just provided the figure for the cost of goods sold. In the real world, this is not a number that is pre-defined or magically calculated. Companies are actually required to figure out how to calculate the cost of goods sold based on cost flow assumptions or other accounting methods
In the next few lessons we will be covering the four different ways to find inventory costing including specific identification, FIFO (first in, first out), LIFO (last in, first out) and average cost.
We will first discuss why the cost of goods is important and then we will cover the first method of specific identification.
Whether a company using a periodic or perpetual inventory system, they will need to come up with the final value for the expense of the inventory sold. This is referred to as the cost of goods sold, which is often referred to using the acronym COGS. In order to calculate the cost of goods sold, they must have a way to assign cost to each inventory item.
The ending inventory is what is left at the end of the accounting period and recorded on the balance sheet. Without a way to calculate COGS and ending inventory, the company would end up with inaccurate values on both the income statement and balance sheet.
With specific identification, the company marks every inventory item in order to easily identify the cost of inventory items and come up with inventory. The identification is in the form of a tag or barcode that specifies the cost of the item.
Normally this system is used for big ticket items with higher sales prices such as vehicles, rare artwork or large smart TV's. It is not feasible for the company to individually tag thousands and thousands of small unit-cost items, hence the use for high value items that are sold in a limited variety.
Let's take a look at a simple example of how specific identification is used for inventory costing. For example, let's say a car dealership has sold three vehicles out of inventory: one with a cost of $20,000, one with a cost of $17,000 and one with a cost of $12,000. Each vehicle on a car lot is tagged with the cost identified to that particular vehicle.
The total cost of goods sold for the inventory would be $49,000 which would be reported as a journal entry. This figure would ultimately be recorded on the income statement.
Every company will double check the cost of goods sold by performing an ending inventory count. This applies to both the perpetual and periodic inventory systems.
In the next lesson, we will be reviewing the FIFO method which is the most complex of the three inventory costing methods.