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Inventory is extremely important for a business. The reason behind understanding value of inventory at a point in time is to accurately report what the value of the inventory (asset) is for a company (Kimmel, Kieso, & Weygandt, 2011). If the asset of a company is worth less than what the market is willing to pay for it than the company will not make money on selling those goods. Also, knowing the price the inventory was purchased at compared to what the market price is currently is important to state what amount of value dropped between those two points of time. That difference in value could be a loss for the company if the price of that good does not rise before the goods are sold.
There are three cost flow assumptions used in general practice and accepted today. These assumptions are First-In, First-Out (FIFO), Last-In, Last-Out (LIFO) and Average-cost. Most companies tend to use a standard cost method throughout a period then recalculate using one of the three accepted methods to adjust goods sold in that period. FIFO is used when inventory is cycled and allowed to move in a cyclical fashion without becoming stagnant unless inventory movement stops. LIFO is likely employed when goods just coming in are the first to be sold. This means the goods sold to customers should use the cost of the most recent purchases to calculate cost-of-goods sold. If a portion of inventory sits for a long time and is not sold a LIFO system is likely used. The Average-Cost method will be used to simple average the cost of the total amount of inventory and spread that cost among all sales. Companies using this method are likely to experience less cost volatility of goods purchased and therefore less likely to need to worry about price fluctuations (Kimmel, Kieso, & Weygandt, 2011).
Kimmel, P. D., Kieso, D. E., & Weygandt, J. J. (2011). Financial accounting: Tools for business decision making. Hoboken, NJ: John Wiley & Sons.
Vincent Triola. Sat, Feb 13, 2021. Why is inventory important & different from other business assets? Retrieved from https://vincenttriola.com/blogs/ten-years-of-academic-writing/why-is-inventory-important-different-from-other-business-assets