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Accounting: FIFO/LIFO, Weighted Average, and Specific Identification 3 Views


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00:00

Accounting Allah shmoop FYE Foe and Life Oh weighted Average

00:06

and Specific Identification Fife Oh life Oh are weighted average

00:14

and specific identification as in real life in the world

00:18

of accounting time and timing matter Costs of inventory change

00:23

all the time Not only is inflation always at work

00:25

in the background but competitive dynamics of buyers and suppliers

00:28

change regularly And there's a big strike at a Pittsburgh

00:31

steel mine And all of a sudden the cost of

00:34

steel goes up a lot The strike ends and the

00:37

cost of steel plummets Companies that hold a meaningful amount

00:40

of inventory shelter themselves from this kind of volatility because

00:44

you can imagine the situation where a strike happens in

00:46

the key supply chain elements of AH bike manufacturer But

00:50

where the manufacturer holds a year's worth of inventory in

00:53

its warehouse Yeah you're not likely going to be too

00:56

nervous about a strike lasting more than a year because

00:58

all the workers would go bankrupt and starve and move

01:01

on Right So you'll allow your inventory reserves to be

01:04

depleted for awhile and replenish them when inventory costs go

01:08

back down after the strike Note that these volatile changes

01:11

which happens all the time are regularly mitigated by long

01:15

term contracts established from manufacturers and their component parts suppliers

01:20

That is it would be reasonable and rational for you

01:22

to contract with Hold the brakes dot com So you

01:25

pay thirty dollars per break unit and have a guaranteed

01:28

output of those units at a maximum price of thirty

01:31

two bucks a unit for say two years Otherwise you

01:34

might have been able to pay only thirty dollars for

01:37

that unit But in paying the extra two dollars for

01:40

the contract you're essentially buying supply line or supply lifeline

01:44

insurance in the unlikely event of a strike Essentially what's

01:47

happening here is that you are paying two dollars in

01:50

unit as a call option against inventory supply at thirty

01:54

bucks a share of its unit based cost Well this

01:57

structure is common vehicle through which most of large corporate

02:00

America ensures a steady stable supply of inventory so that

02:04

they can continue doing the voodoo They do Yeah Okay

02:08

So how does this concept apply to the application of

02:10

Fife Oh and life accounting Well let's imagine a world

02:14

where companies have not de risk their supply chains and

02:18

instead just allow the pricing or cost of their inventory

02:21

to remain volatile like it just floats with market prices

02:25

Let's presume there's a world where bike frames had massive

02:28

very ability in costs last month Frames cost one hundred

02:31

bucks each the previous month They cost one hundred fifty

02:34

dollars each month For that there were two hundred dollars

02:37

each And remember that your little bike company replenishes all

02:40

of its inventory immediately at the end of each month

02:43

in which it was depleted Still you sell a bike

02:45

for five hundred dollars this month All the other components

02:47

cost the same In the total cost your bike was

02:50

two hundred fifty dollars That two fifty presumes that the

02:53

cost of a bike frame was one hundred bucks or

02:55

forty percent of the total cost of the bike So

02:57

do you keep the hundred dollars from last month as

03:00

your price or do you keep one hundred fifty That

03:02

frame cost you last month or should you be using

03:06

the two hundred dollars price per frame that you incurred

03:09

two months ago Well there are a bunch of ways

03:11

to think about which cost structure to apply All our

03:13

legal But once you choose a method of accounting for

03:16

your inventory cost you have to stick with it If

03:19

you use life last in first out as your method

03:22

well you'd apply the last frame cost the last one

03:25

in or that hundred dollars a frame costs and your

03:27

accounting would be as outlined so that a bike unit

03:30

sold did indeed cost you two hundred fifty bucks But

03:32

if you use Fife oh first in first out While

03:36

the numbers would be completely different all of a sudden

03:38

the cost of the bike is no longer to fifty

03:40

But rather it reflects the first in our first purchased

03:44

bike frames which cost two hundred dollars apiece making the

03:47

total cost of your bike skyrocket from two hundred fifty

03:50

dollars a unit three hundred fifty dollars a unit Well

03:53

the same frames have been sold The same bike configuration

03:57

has been sold The same five hundred dollars has been

04:00

invade to buy the bike yet Now you're drawing from

04:02

early original inventory which carried a very high price per

04:07

unit thus showing much lower unit profit margins You know

04:12

per unit sold right Well why would a company want

04:14

to show lower profits Well of course there is a

04:17

little matter of taxes Taxes are assessed on profits not

04:21

revenues and in showing lower profits the cash flow of

04:25

the company doesn't change at all with the exception that

04:28

fewer cash dollars will go out the door at year

04:31

end to your friendly loving I Rs people if you

04:34

apply the earlier high cost bike frame numbers to your

04:37

expenses line in the income statement What this wrestling match

04:41

is common in successful companies Imagine that the first few

04:44

automobile frames that Tesla ordered were very small in number

04:48

and maybe they were ordering a thousand frames at a

04:51

time So they're early inventory gains none of the scale

04:54

advantage or volume discounting or robot ing of the same

04:58

frames they might be ordering today in buckets of fifty

05:02

thousand units Well there's no right or wrong answer in

05:04

applying five for life on companies that simply want a

05:07

blended average cost can do that as well Shockingly the

05:10

weighted average concept is a blend of all the cost

05:13

to create whatever inventory is currently housed in the given

05:17

warehouse Example your bike company ordered fifty frames of two

05:20

hundred bucks seventy five frames at one fifty and two

05:23

hundred frames His last month at one hundred while they're

05:25

total cost was forty one thousand two hundred fifty bucks

05:28

for three hundred twenty five frames So if you simply

05:31

divide out that money you spent to buy all those

05:34

three hundred twenty five frames you'll magically arrive at the

05:37

weighted average cost of a bike rain which is right

05:39

there One hundred twenty seven dollars Well typically each month

05:42

Then you would simply update your costs and volumes related

05:46

to inventory and the weighted average cost would move up

05:50

for down of it Well obviously the more inventory you

05:52

keep on hand the less the weighted average number will

05:55

move each month as you re stock inventory in you

05:59

know the supply chain kind of keep well Ah forthe

06:01

means of tracking inventory buying beyond Scifo in life Oh

06:05

and weighted average cost thing he's here is called specific

06:09

identification Well in this method individual buckets are tracked individually

06:14

and matched with specific sales So let's say you build

06:17

rockets for a living which take payloads of satellites test

06:20

monkeys and crazy billionaires who want to live forever into

06:23

space A given rocket might last for twenty launches and

06:26

it returns and is built in a custom manner such

06:29

that the revenues from its sale can easily be matched

06:32

with costs to build them like any component part or

06:35

input or system or guidance Telemetry grid that it took

06:39

toe launch that rocket into space The fuse lodge of

06:42

the rocket might have cost of eighteen million dollars to

06:45

frame in a fancy metal The cost of that fuse

06:47

Lodge for eighteen Mill would be specifically identified in match

06:50

to its eventual sales price of two hundred fifty million

06:53

dollars Right OK one more application for you before we're

06:56

done here Basket purchases Let's say you have a bike

06:59

parts supplier who comes to you asking if she can

07:01

supply the bike frame Two wheels and a brake system

07:04

all for one hundred twenty five bucks a unit This

07:06

is a cost savings of about twenty five dollars From

07:08

what you've been paying right you've been paying one fifty

07:10

Now you get to pay one twenty five for the

07:12

same thing Maybe there's even more savings If you wanted

07:15

to take her up on that deal well how would

07:17

you account for the bike frame as a unit going

07:19

forward Well suppose someone is in a race hits a

07:22

mailbox and the frame is twisted It needs to be

07:24

replaced Well how would you calculate the cost of that

07:27

frame It used to be easy when you paid a

07:29

hundred dollars ala carte for one frame but now you

07:33

have what's called a basket purchase or a bundle Yes

07:37

it bundles together a few different items but now you

07:40

have to take out the things that aren't the frame

07:43

in the one twenty five that you paid So what

07:45

do you do Well most likely you'd apply a total

07:48

cost percentage and then kind of back out the actual

07:51

costs after you'd taken your blindfold off and stop throwing

07:55

darts in the old days of frame represented seventy percent

07:58

of the cost of the three separate units when they

08:00

were bought Allah look hard so it would be rational

08:03

to just apply that same percentage under the basket purchase

08:06

system Then you would just apply a cost of point

08:08

seven times one Twenty five or get eighty seven fifty

08:11

now as the new cost of your frame Okay so

08:14

what we go through here We had for four different

08:15

ways of accessing inventory cost We had FIFA we had

08:19

life But we had the weighted average of our inventory

08:23

of what things work and we had specific identification and

08:26

we kind of extrapolated basket purchases inside of that So

08:30

that's it That's the group Let's figure out your inventory

08:33

costs and move on from there And while all this

08:36

is just one example of a you know a basket

08:38

case

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