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Inventory Accounting: Systems, Costing Methods and Controls

Inventory is the stock of goods a business holds to sell. Inventory accounting decides how much the goods sold cost (cost of goods sold) and how much the goods left are worth (closing inventory). When prices change, the answer depends on the costing method: FIFO or weighted average (specific identification for unique items). Businesses track stock with a perpetual or periodic system, count it physically, protect it with internal controls, and watch how fast it sells with inventory turnover.

🎬 Step-by-step story

  1. Stock arrives in layers with different prices: 10 units at 10, 20 at 12 and 10 at 15. Altogether 40 units costing 490.
  2. FIFO means first in, first out. Selling 25 units uses the 10 oldest units, then 15 from the next layer. COGS is 280; 210 of stock is left.
  3. Weighted average mixes all layers: 490 ÷ 40 = 12.25 per unit. COGS is 25 × 12.25 = 306.25; stock left is 183.75.
  4. Prices were rising, so FIFO gives a lower cost of goods sold, a higher profit and a closing stock closer to today’s prices.
  5. If closing stock is counted 50 too high, profit is 50 too high this year. Turnover tells how many times stock is sold: 280 ÷ 155 ≈ 1.8 times.
  6. Your turn: change the units sold and switch between FIFO and average. COGS plus closing stock always equals 490.

Tip: drag the 3D scene to turn it. Use two fingers to zoom.

🤔 Common doubts, cleared

Does FIFO mean I must sell the oldest box first?

No. FIFO is a rule for costs. The goods can leave in any order; we just assign the oldest costs to COGS first.

Why is the average 12.25 and not 12.33?

There are more units at 12 than at the others. Divide total cost by total units so each unit counts, not each price.

Why does the method change profit if the same goods were sold?

Each method moves a different share of the 490 into COGS. The rest stays as closing stock, so profit changes.

Why does a higher stock count increase profit?

COGS = goods available − closing stock. A bigger closing stock makes COGS smaller, so profit is bigger.

Is a high inventory turnover always good?

Usually it means stock sells fast. But very high turnover can mean the shelves are often empty and sales are lost.

Is the total cost different under each method?

No. COGS + closing stock is always 490; only the split changes.

Inventory accounts and the two inventory systems

Merchandise inventory is a current asset: goods bought to resell. Linked accounts are Purchases, Purchase returns, Purchase discounts, Freight-in, Sales, Sales returns and Cost of goods sold (COGS).

PerpetualPeriodic
When is stock updated?After every purchase and saleOnly after the count at period end
Buying goodsDr Inventory, Cr Accounts payableDr Purchases, Cr Accounts payable
Selling goodsDr Accounts receivable, Cr Sales and Dr COGS, Cr InventoryDr Accounts receivable, Cr Sales only
COGS foundAny time, from the recordsOpening + net purchases − closing count
Good forShops with scanners and softwareSmall shops with cheap, many items

Inventory valuation methods: FIFO and weighted average

When the same item was bought at different prices, we need a rule for which cost goes to COGS.

Effects: when prices rise, FIFO gives lower COGS, higher profit, higher tax and higher closing stock. Average gives results in the middle and smooths price jumps. When prices fall, the effects reverse. Whatever method is chosen, it must be used consistently.

Counting stock and the effect of inventory errors

Even with a perpetual system, goods are counted by hand (a physical inventory) at least once a year, usually at year end or when the shop is closed or quiet. Steps: stop goods moving in and out, use pre-numbered count sheets, count in pairs (one counts, one checks), compare with the records, and investigate differences (theft, damage, errors).

An error in closing stock passes straight into profit:

Safeguarding stock, internal controls, technology and turnover

Internal controls protect stock and keep records true: lock storerooms, limit who can enter, separate duties (the person who keeps stock does not keep the records), use pre-numbered receiving and issue slips, do surprise spot counts, and insure stock.

Technology: barcode scanners and point-of-sale tills update stock at each sale; RFID tags track pallets; accounting software (Tally, QuickBooks, Zoho, SAP) keeps inventory, COGS and reorder levels automatically and warns when stock is low.

Inventory turnover = COGS ÷ average inventory, where average inventory = (opening + closing) ÷ 2. Days in inventory = 365 ÷ turnover. A higher turnover means stock sells fast (less money stuck, less spoilage). Too high may mean shelves run empty. Compare with past years and similar businesses.

Key formulas and definitions

Worked examples

1. Opening 10 units @ 10; purchases 20 @ 12 and 10 @ 15. Find total units and cost available.

Units: 10 + 20 + 10 = 40. Cost: 100 + 240 + 150 = 490.

2. Using these layers, 25 units are sold. Find COGS and closing stock by FIFO.

Oldest first: 10 × 10 = 100, then 15 × 12 = 180. COGS = 280. Left: 5 × 12 + 10 × 15 = 60 + 150 = 210. Check: 280 + 210 = 490.

3. Same data, weighted average method.

Average = 490 ÷ 40 = 12.25. COGS = 25 × 12.25 = 306.25. Closing = 15 × 12.25 = 183.75. Check: 306.25 + 183.75 = 490.

4. The 25 units sold for 20 each. Find gross profit under each method.

Sales = 500. FIFO: 500 − 280 = 220. Average: 500 − 306.25 = 193.75. FIFO profit is higher because prices were rising.

5. Closing stock should be 210 but was counted as 260. What happens to COGS and profit this year and next year?

COGS is 50 too low, so this year’s profit is 50 too high. Next year’s opening stock is 50 too high, so next year’s COGS is 50 too high and profit 50 too low.

6. Opening inventory 100, closing 210, COGS 280. Find inventory turnover and days in inventory.

Average inventory = (100 + 210) ÷ 2 = 155. Turnover = 280 ÷ 155 ≈ 1.81 times. Days = 365 ÷ 1.81 ≈ 202 days.

Common mistakes

Practice quiz

1. Under FIFO the closing stock is valued at:
2. Total cost 900 for 60 units. Weighted average cost per unit is:
3. In a perpetual system a sale is recorded with:
4. Closing stock is understated by 300. This year’s profit is:
5. COGS 600, average inventory 150. Inventory turnover is:

Practice: answer these yourself

Type or choose your answer, then press Check. Use a hint if you are stuck; the full solution appears after you answer.

Frequently asked questions

What is the difference between FIFO and weighted average?

FIFO sends the oldest costs to cost of goods sold first. Weighted average gives every unit the same average cost, found by dividing total cost by total units.

Why is LIFO not used in India?

Ind AS 2 and IFRS do not allow LIFO, because it can show stock at very old, unrealistic costs.

What does inventory turnover show?

How many times the average stock is sold in a year. Higher turnover means goods sell faster and less money is tied up in stock.

Where this is taught

Canada (Ontario)Grade 12Service and Merchandising Businesses
Canada (Ontario)Grade 12Accounting Practices for Assets

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