Assumptions Used in Calculating CoGS under the Periodic Method

Of course, the calculation of CoGS is a bit more complex out in the real world. For example, if a business is dealing with changing per-unit inventory costs, assumptions have to be made as to which ones were sold (the cheaper units or the more expensive units).

EXAMPLE: Maggie has a business selling t-shirts online. She gets all of her inventory from a single vendor. In the middle of April, the vendor raises its prices from $3 per shirt to $3.50 per shirt. If Maggie sells 100 shirts during April—and she has no way of knowing which of those shirts were purchased at which price—should her CoGS be $300, $350, or somewhere in between?

The answer depends upon which inventory-valuation method is used. The three most used methods are known as FIFO, LIFO, and Average Cost. Under GAAP, a business can use any of the three.

First-In, First-Out (FIFO)

Under the “First-In, First-Out” method of calculating CoGS, we assume that the oldest units of inventory are always sold first. So in the above example, we’d assume that Maggie sold all of her $3 shirts before selling any of her $3.50 shirts.

Last-In, First-Out (LIFO)

Under the “Last-In, First-Out” method, the opposite assumption is made. That is, we assume that all of the newest inventory is sold before any older units of inventory are sold. So, in the above example, we’d assume that Maggie sold all of her $3.50 shirts before selling any of her $3 shirts.

EXAMPLE (CONTINUED): At the beginning of April, Maggie’s inventory consisted of 50 shirts—all of which had been purchased at $3 per shirt. Over the month, she purchased 100 shirts, 60 at $3 per shirt, and 40 at $3.50 per shirt. In total, Maggie’s Goods Available for Sale for April consists of 110 shirts at $3 per shirt, and 40 shirts at $3.50 per shirt.

If Maggie were to use the FIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $300. (She had 110 shirts that cost $3, and FIFO assumes that all of the older units are sold before any newer units are sold.)

100 x 3 = 300

If Maggie were to use the LIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $320. (LIFO assumes that all 40 of the newer, $3.50 shirts would have been sold, and the other 60 must have been $3 shirts.)

(40 x 3.5) + (60 x 3) = 320

It’s worth pointing out that the two methods result not only in different Cost of Goods Sold for the period, but in different ending inventory balances as well.

Under FIFO—because we assumed that all 100 of the sold shirts were the older, $3, shirts—it would be assumed that, at the end of April, her 50 remaining shirts would be made up of 10 shirts that were purchased at $3 each, and 40 that were purchased at $3.50 each. Grand total ending inventory balance: $170.

In contrast, the LIFO method would assume that—because all of the newer shirts were sold—the remaining shirts must be the older, $3 shirts. As such, Maggie’s ending inventory balance under LIFO is $150.