 Hello, in this lecture we're going to talk about estimating inventory methods, methods such as first in, first out, last in, first out, and the average method. Last time we talked about specific identification when we were selling the inventory of forklifts. We used specific identification, meaning we had an ID number for each particular forklift, and knew exactly which forklift we sold, and the cost of that particular forklift. Reason that makes sense for forklifts is because they're relatively large, they could be distinct in nature, and they have a fairly large dollar amount in comparison to other types of inventory. If we're selling something else like coffee mugs over here, we may have a large amount of coffee mugs, they may be all completely the same, and therefore for us to give them all identification numbers and try to track exactly which mug we sold, and the cost of that particular mug may not be of good use of our time, may be better to use some type of estimating method in that case, being first in, first out, last in, first out, or an average method. So let's compare and contrast those methods briefly, and then we'll go into more detail at a later time. In this example, we're going to say that we purchased inventory in terms of coffee mugs. We're going to buy and sell coffee mugs. In January, we bought this many coffee mugs, like eight or something here, at a dollar. Then in April, we bought another amount of coffee mugs, like five more at 120, point being that the coffee mugs are going up in price, even though they're exactly the same, the cost is going up. That's going to be the typical assumption. All else equal, prices go up. Why? Because of inflation. The value of the dollar goes down. The price could go down as well, if, for example, the glaze or something, a coffee mug became cheaper, that the norm would be that prices go up and then everything would be reversed if prices go down. That's how I like to think of it, at least. Then in July, we purchased another bunch of coffee mugs at $1.50, price going up again. We haven't sold any coffee mugs yet in this particular example. We're stockpiling them, expecting to sell them at some particular point in time. We now have on our balance sheet, $23, which would be this number of coffee mugs times $1 plus this number of coffee mugs times $120 plus this coffee mug times $150. That's the $23 we have on our balance sheet as inventory at this time. We then have a customer asking for a coffee mug. We make our first sale of the coffee mug. We're going to sell them all for $5. That's not the issue here. The issue is how much is the cost of that coffee mug? What's going to be the cost? Is it a dollar? Is it $120? Is it $150? We're not going to use specific identification. I'm not going to say, well, let's see which actual mug was picked here. We're going to first use first in, first out as our first example. In that assumption, and it is just an assumption, we're going to assume that that coffee mug was taken from this area in terms of $1 being the cost rather than $120 rather than $150. This is the most intuitive method for most people to understand because it usually follows what we think of as a normal flow of inventory. We would assume that we would try to sell the oldest types of inventory first, even if they're non-perishable, something like a coffee mug, but it's important to note that this is just an assumption. For example, if we put all the new, all the old coffee mugs up front on the shelf and the new coffee mugs on the back, it is possible for the customer to reach in the back and take the old coffee mug. It's important to note that we are not talking about the actual flow of coffee mugs, although this may mirror what we try to have the actual flow to be, but it is just an estimate. If we have that estimate, then we're going to say that the sales price is $5, so we're going to say we sold it on an account here. We probably would have sold it for cash if it's a coffee mug, but we're going to sell it on an account. $5 going up for accounts to see both sales goes up by that $5. That has nothing to do with our cost. We might have used the cost in order to come up with that $5, but it has nothing to do directly with the cost. What we're tracking now is the inventory being reduced, in this case, by $1 rather than $120 rather than $150 under the first and first out method and the cost of goods sold being the $1. The expenses are going up by $1. We're going to reduce our inventory by that $1. That means that if we look at what's left, we're going to say the inventory was at $23 minus that $1. We now have Indian inventory of the $22 at this point in time under the first in first out method. We could make another assumption, though. We could say, well, why don't we assume under a last in first out method that this particular coffee mug that we sold this first one was taken from the last batch that we bought, the most expensive batch in this case, at the $150. Most people kind of balk at this one because they say, well, that doesn't really make sense. We would try to sell the old ones first. That might be the case, but you can make a reasonable argument to say, hey, if it's just an estimate, I don't know which coffee mugs we sold. It's just as reasonable assumption to say that a coffee mug down here was sold as a coffee mug up here. Why would we want to make that assumption? Well, in terms of rising prices, we'll see that what will happen is that our net income will actually be reduced. So it's possible that this first method came up through taxes of need of desire to have a lower net income. But we'll discuss that later. It's a good example in terms of a difference in methods and how a different method can result in differences on the financial statements and differences in net income. So if we make this assumption, we have the same sale. We're going to say we're going to sell it for $5. The sales price isn't going to be affected by the type of method that we are going to use. But the inventories now are going to go down by $150 rather than the dollar. The cost of goods sold is going to be $150. So the expense is higher, making net income lower. What happens to our balance sheet account? Well, we were at $23 giving us a $21.50 that is left in Indian inventory after the last and first out assumption. The last assumption we can have is going to be somewhere in the middle, and we call that the average. So we can use the average method and we can say, hey, you know what, I don't know which mug we sold. I don't know which, if we sold the dollar mug or the $120, the $150, I'm not going to go in there and figure that out. I'm not going to make an assumption. We're going to say that we sold mugs that cost about $121. It's going to be somewhere in the middle. Now, how do we get that average? It's not going to be adding the 1, the $120, the $150 and dividing by 3. What we would have to do is take the weighted. We'd have to say that we'd have to take this number of cups times 1 plus this number of cups times $120 plus this number of cups times $150 and divide that dollar amount by the number of cups. But we'll talk about that later. What we need to know now is that we can say, whatever we cup we sold, it cost about $121. And if we record that then, same sales price, but now the inventory is going down by $121 and the cost of goods sold will be that $121. What's left on our balance sheet then, we have the inventory at $23. That one cup is now bringing it down to $2179. So the essence of this is that they are estimates. So if we look at just the recap in terms of rising prices, this is how things will always be. If prices go down, you want to flip everything, meaning cost of goods sold under a first and first out was $1. Under last and first out, it's always going to be higher in a period of rising prices when the prices go up as we purchase it. The middle area is going to be the average. So the average is always going to be in between. Then we're going to have the Indian inventory. What's going to be left? We want to know both the income statement side cost to get sold and the balance sheet side. What's left on the balance sheet and what's left under FIFO 22. What's left under LIFO 2150 and what is average is going to be somewhere in the middle. This is what's left on the balance sheet. Then we're going to say net income. What was the impact on net income under FIFO? We had $4 net income under LIFO. We had the smallest amount of net income, $3.50. Under average, we have the amount in the middle at $3.79. You can see that in a period of rising prices, a normal time period, FIFO actually makes us look the best, meaning our net income is the highest and our Indian inventory is the highest. LIFO last and first out will make us look the worst, meaning our net income is the lowest and our Indian inventory is the lowest and the average will always be in the middle. If prices went up, all that would be flip-flop.