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Merchandise Operations
Merchandise Operations: Inventory consists of finished goods, partially finished goods, and raw materials. A manufacturing firm might have raw materials and partially finished goods that require further processing while retail might have finished goods that are awaiting shipment at the end of the financial period. The method used for inventory costing directly affects the cost of good which affects the gross profit and net income.
The periodic inventory costing system uses the physical inventory counts the estimates for the cost of goods for closing inventory balance since it does not track inventory daily. Moreover, the perpetual inventory costing method updates each sale and purchase thereby continually updating the inventory and cost of goods balance. First-in-first-out, last-in-last-out, specific identification and weighed average costing are the most common valuation methods (Michael 2012). Costs of inventory include but not limited to shipping, acquisition, and direct costs.
During inflation, FIFO costing flow method is likely to give high ending inventory. If the inventory is high, the net income is also expected to be high. FIFO method uses the assumption that the first purchased inventory item becomes the first one to be used in production or sold (Chirantan 2016). Therefore, when there is inflation in the market, the cost of goods in the income statement consists of the less expensive items. However, the ending inventory includes the most expensive items. As a result, the amounts of ending inventory and net income are high.
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It is, therefore, impeccable that a company applies different inventory costing methods to counter inflation and deflation. Under LIFO method, ending inventory and net income is lower than under FIFO method. When weighted average costing method is used, inventory cost is high and net income is low during inflation (Michael 2016). Specific identification method provides net income that is dependent on acquisition costs of inventory. Therefore, FIFO is the only costing method that produces high inventory and high-income amounts during inflation.
References
Chirantan Basu (2016). How different inventory methods can affect net income. Retrieved from http://smallbusiness.chron.com/different-inventory-methods-can-affect-net-income-34570.html
Michael Celender (2012). FIFO method, LIFO method, and Weighted average cost. Retrieved from http://www.accounting-basics-for-students.com/fifo-method.html
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