In a perpetual inventory system, the inventory records are continuously updated with each purchase and sale, allowing for real-time tracking of inventory and cost of goods sold (COGS). Four methods are used to determine COGS:
This method tracks the actual cost of each individual item sold. For example, if Mead Electric sells a generator, the exact cost of that unit (e.g., $1,000 or $1,200) is recorded as COGS based on its purchase invoice.
Advantages: Highly accurate as it matches the exact cost with revenue, ideal for high-cost, unique items (e.g., cars, jewelry).
Shortcomings: Impractical for large volumes of similar, low-cost items due to extensive record-keeping requirements.
This method calculates an average cost per unit after each purchase (total cost ÷ total units). For Mead Electric, after buying 2 units at $1,000 and 3 at $1,200, the average cost is $1,120, used for COGS when one unit is sold.
Advantages: Simple and smooths out price fluctuations, suitable for homogeneous items.
Shortcomings: Does not reflect actual physical flow and may distort profits during rapid price changes.
Assumes the earliest goods purchased are sold first. For Mead, selling one generator uses the $1,000 cost from January, leaving newer costs ($1,200) in inventory.
Advantages: Matches physical flow in many cases (e.g., perishables), reports higher profits and inventory values during rising prices.
Shortcomings: Can inflate taxable income in inflationary periods, not ideal for tax minimization.
Assumes the most recently purchased goods are sold first. For Mead, COGS is $1,200 from February, leaving older costs ($1,000) in inventory.
Advantages: Reduces taxable income during rising prices (higher COGS), widely used in the U.S. for tax benefits.
Shortcomings: Inventory values may be outdated (lower than current costs), not allowed under international standards (IFRS).
Each method affects financial statements differently, and consistency in application is key under generally accepted accounting principles (GAAP). The choice depends on the nature of inventory, cost trends, and management goals (e.g., tax strategy vs. profit reporting).