Listen to the following recording, which explains the AVG COST example. Click on the Show-Hide link to see the solution.
Alright. Well, let's make another assumption. Let's assume that we're going to use average cost, because a T-shirt is a T-shirt is a T-shirt is a T-shirt. So we're not going to really care about our T-shirts.
Using average cost, we set up our grid the same way. And we start out exactly the same way we did in FIFO and LIFO, 17 units in our inventory. We sell 13 of them, because that's all we have to sell. And we're left with four, to which we add 15.
We add 15 units with a cost of $675. I add the four units that I was left with plus the 15 new ones to show a total of 19 units in inventory. I total cost of that inventory to end up with $835 of inventory.
When I divide my cost by my number of units, I come out with an average cost of $43.95 per unit. And this makes sense, because I only had four units left at $40. And I bought 15 at $45. So my average should be closer to $45 than it is to $40, because I have more at a higher cost.
On the 16th of May, I bought another nine at yet another high cost of $49, for a total of $441. I moved the nine units into my merchandise inventory. I moved the $441 into my merchandise inventory. And now I have a total of 28 units with a cost of $1,276.
When I divide the total cost by the number of units, I come out with $45.57. Again, it is over the original $45, but that's because my cost of nine units jumped again, very high.
All right, on the 18th of May, I sell 11 of those units. So I move 11 units with an assigned cost of $45.57 into the cost of goods sold. Now when I calculate that out, I come up with $501.27 cost of goods sold.
If I do a quick calculation of what's left, I have 17 units left. But if I multiply 17 units in my inventory by the assigned cost per unit, I don't come up with the correct number, and the reason being rounding. Remember, we're talking about percentages of pennies. So in order to make average cost work, what you've got to do is you've got to fudge your numbers a little bit.
So what I did was I took $1,276, which is what I had invested in my inventory. I subtracted out the $501.27 that I sent over to cost of goods sold. And that gave me a cost of $774.73. It's pennies. It'll work itself out.
On the 20th of May, I sold 14 more units. The same units got sold, which left me with three in my inventory. And then, on the 28th of May, I bought eight more.
Well, I added those eight to the three, and I got a total of 11 units. I added the cost of the eight to the cost of the three and I came up with $544.75. When I do my calculation, I end up with a final cost per unit in inventory of $49.52.
Now how does this affect my gross profit? Well, when I do my gross profit, I had the same sales. I subtract out my cost of goods sold. And I come out with a gross profit of $949.75.
That is in between the gross profit that we've received when we had FIFO and when we had LIFO. And it should be because, in FIFO, we sold our cheapest products, which gave us a low cost of goods sold and a high profit. In LIFO, we sold our expensive products, which gave us a high cost of goods sold and a low profit. In average cost, we averaged them, so it should come out in between the two. And it does.
So hopefully, this explains why different companies will select different inventory flow systems and how it will affect their bottom line. The thing to remember is that, once you have determined that you are going to use a certain flow system, as far as determining the cost of your goods sold, you must stay with that system. You can't flip-flop back and forth from year to
T'sIzzWe has the following information concerning its purchases and sales for the month of May. Determine the gross profit.
Well, now what? Let's use AVG COST.
Now let's set up a grid that lets us track our inventory. I use a system described below that lets me see what I have purchased, what I have sold, and what I have left.
