10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

Inventory Costing Methods and the Perpetual System

Under a perpetual inventory system, every purchase and every sale updates your inventory records in real time. This means you need a consistent method for deciding which costs get assigned to the units you sell (Cost of Goods Sold) and which costs stay with the units still on hand (Ending Inventory). The four main methods for making that assignment are specific identification, FIFO, LIFO, and weighted-average.

Cost of Goods Sold Calculation Methods

Each method uses the same pool of costs but assigns them differently. Here's how each one works:

• Specific identification tracks the actual cost of each individual item. When you sell a unit, you record the exact cost you paid for that unit as COGS. This works best for unique, high-value items (cars, jewelry, custom furniture) where each unit is distinguishable.
• First-in, first-out (FIFO) assumes the oldest units in inventory are sold first. COGS is calculated using the costs of the earliest purchases still available. Think of it like a grocery store rotating milk: the oldest cartons go out the door first.
• Last-in, first-out (LIFO) assumes the newest units are sold first. COGS is calculated using the costs of the most recent purchases. Under a perpetual system, you apply LIFO at the time of each sale, using the most recent cost layer available on that date.
• Weighted-average (called "moving average" in a perpetual system) recalculates the average cost per unit after every purchase. The formula is:

$\text{Average Cost per Unit} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}$

When a sale occurs, you multiply this current average cost by the number of units sold to get COGS. The average is then recalculated again after the next purchase.

Impact on Inventory Valuation

The method you choose directly affects three numbers on your financial statements: COGS, ending inventory, and gross profit. These effects are most noticeable when prices are changing.

• Specific identification values ending inventory at the actual costs of the unsold items. Gross profit reflects the real margin on each item sold. Because you can choose which specific items to sell, this method can potentially be used to manipulate income.
• FIFO values ending inventory at the most recent purchase prices (since the oldest costs were sent to COGS). During periods of rising prices:
  • COGS is lower (older, cheaper costs flow out)
  • Gross profit is higher
  • Ending inventory is higher (newer, more expensive costs remain on the balance sheet)
• LIFO values ending inventory at the oldest purchase prices (since the newest costs were sent to COGS). During periods of rising prices:
  • COGS is higher (newer, more expensive costs flow out)
  • Gross profit is lower
  • Ending inventory is lower (older, cheaper costs remain on the balance sheet)
• Weighted-average produces results that fall between FIFO and LIFO for COGS, ending inventory, and gross profit. It smooths out price fluctuations rather than assigning the extremes.

Recording Transactions in a Perpetual System

Every inventory transaction requires two journal entries in a perpetual system: one for the revenue side and one for the cost side.

When you purchase inventory:

• Debit Inventory (asset increases)
• Credit Accounts Payable or Cash (liability increases or asset decreases)

When you record a sale (cost side):

• Debit Cost of Goods Sold (expense increases)
• Credit Inventory (asset decreases)

The dollar amount credited to Inventory depends on which costing method you're using:

1. Specific identification: the actual cost of the specific item sold
2. FIFO: the cost of the oldest available unit(s)
3. LIFO: the cost of the most recently purchased unit(s)
4. Weighted-average: the current average cost per unit

Adjusting for shrinkage: Even though the perpetual system tracks inventory continuously, companies still perform periodic physical counts. If the physical count is lower than what the records show (due to theft, damage, or errors), you record an adjusting entry:

• Debit Cost of Goods Sold (or a separate shrinkage expense account)
• Credit Inventory

Additional Inventory Concepts

• Periodic inventory system: Unlike the perpetual system, a periodic system only updates inventory balances at the end of a period (monthly, quarterly, etc.) rather than after each transaction. COGS is calculated at period-end using beginning inventory + purchases − ending inventory.
• Just-in-time (JIT) inventory: A strategy that minimizes holding costs by receiving goods only as they're needed for production or sale, reducing the amount of inventory sitting in a warehouse.