10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method

Inventory Costing Methods and the Periodic Inventory System

Under the periodic inventory system, you don't track inventory continuously. Instead, you wait until the end of the period, do a physical count, and then calculate cost of goods sold (COGS) and ending inventory all at once. The costing method you choose (FIFO, LIFO, weighted-average, or specific identification) determines which costs get assigned to the units sold versus the units still on hand. That choice directly affects reported profits, so it matters.

Cost Calculation Methods for Inventory

Each method uses the same pool of costs (beginning inventory + purchases) but assigns them differently between COGS and ending inventory.

Specific Identification

This method tracks the actual cost of each individual item. When you sell an item, you assign its specific purchase cost to COGS. It's the most accurate method, but it's only practical for low-volume, high-value goods like cars, jewelry, or artwork. Tracking individual costs for thousands of identical units (like cans of soup) would be unmanageable.

First-In, First-Out (FIFO)

FIFO assumes the oldest units purchased are sold first. That means ending inventory is made up of the most recently purchased items. Think of a grocery store shelf where older milk gets pushed to the front and sold before newer cartons.

Last-In, First-Out (LIFO)

LIFO assumes the most recently purchased units are sold first. Ending inventory therefore consists of the oldest costs. This doesn't have to match the physical flow of goods; it's just a cost flow assumption. Note that LIFO is allowed under U.S. GAAP but is not permitted under IFRS.

Weighted-Average Method

This method blends all costs together. You calculate a single average cost per unit and apply it to both COGS and ending inventory:

$\text{Weighted-Average Cost per Unit} = \frac{\text{Cost of Beginning Inventory} + \text{Cost of Purchases}}{\text{Total Units Available for Sale}}$

Then:

• $\text{COGS} = \text{Weighted-Average Cost per Unit} \times \text{Units Sold}$
• $\text{Ending Inventory} = \text{Weighted-Average Cost per Unit} \times \text{Units Remaining}$

This approach smooths out price fluctuations and works well when units are interchangeable.

All four methods use the same fundamental relationship:

$\text{Cost of Goods Sold} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

The difference between methods isn't the formula; it's how you determine the dollar value of ending inventory. Once you know ending inventory, COGS falls out of the equation.

Impact of Costing Method on Financial Reports

The method you choose only creates meaningful differences when purchase prices are changing. During rising prices (inflation), here's how the methods compare:

|FIFO|LIFO|Weighted-Average| |---|---|---|---| | Ending Inventory | Higher (newer, higher costs remain) | Lower (older, lower costs remain) | Between FIFO and LIFO | | COGS | Lower (older, cheaper costs flow to COGS) | Higher (newer, expensive costs flow to COGS) | Between FIFO and LIFO | | Gross Profit / Net Income | Higher | Lower | Between FIFO and LIFO | | Income Taxes | Higher (more reported income) | Lower (less reported income) | Between FIFO and LIFO |

A quick example: suppose a hardware store bought 100 hammers at $\$8$ each in January and 100 more at $\$10$ each in March, then sold 120 hammers during the period.

• FIFO assigns the first 100 units at $\$8$ and 20 units at $\$10$ to COGS = $\$1{,}000$. Ending inventory (80 units at $\$10$) = $\$800$.
• LIFO assigns the first 100 units at $\$10$ and 20 units at $\$8$ to COGS = $\$1{,}160$. Ending inventory (80 units at $\$8$) = $\$640$.
• Weighted-Average cost per unit = $\frac{\$800 + \$1{,}000}{200} = \$9.00$. COGS = $120 \times \$9 = \$1{,}080$. Ending inventory = $80 \times \$9 = \$720$.

Notice that total costs available for sale ($\$1{,}800$) always equals COGS + ending inventory, regardless of method. The methods just split that total differently.

Specific identification doesn't follow a predictable pattern since profits depend on which particular items happen to be sold. This can lead to income manipulation if managers cherry-pick which units to sell.

Periodic Inventory Adjustment Process

Under the periodic system, the inventory account sits unchanged during the period. All purchases go into a separate Purchases account. At period-end, you reconcile everything.

Steps to calculate COGS and update inventory:

1. Perform a physical count of all inventory on hand at the end of the period.

2. Apply your chosen costing method (FIFO, LIFO, or weighted-average) to assign a dollar value to the units counted. This is your ending inventory.

3. Calculate COGS using the formula: $\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

4. Record adjusting entries to update the books. The periodic system requires closing entries that:

   • Remove the beginning inventory balance and the purchases balance
   • Record the ending inventory balance
   • Record COGS for the period

This contrasts with the perpetual system, which updates inventory and COGS with every single sale and purchase transaction throughout the period.

Additional Inventory Considerations

• Lower of cost or market (LCM) rule: If inventory's market value drops below its recorded cost, you must write it down to the lower value. This is a conservative approach that prevents overstating assets on the balance sheet.
• Inventory turnover ratio: Measures how efficiently a company sells through its inventory. Calculated as $\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$. A higher ratio generally means inventory is selling quickly.
• Inventory shrinkage: The difference between recorded inventory and what's actually on hand after a physical count. Causes include theft, damage, and counting errors. Under the periodic system, shrinkage is buried inside COGS since you can't distinguish between items sold and items lost.
• Just-in-time (JIT) inventory: A strategy where companies receive goods only as needed for production or sale, minimizing the amount of inventory held and reducing carrying costs.