Specific Identification Method
It is a way of valuing inventory that tracks the cost of each individual item in stock.
What Is The Specific Identification Method?
The Specific Identification Method is a way of tracking and assigning the cost of each individual item in your inventory. Items such as jewelry, cars, or furniture are the main products businesses opt for this method to maximize profits.
Your cost of goods sold and inventory cost can be precisely determined due to utilizing this method. This is one of the main benefits. Don't rely on guesswork when pricing your merchandise. Instead, pair each item with the precise amount it costs you to purchase.
This way, you won't rely on an average or make assumptions. Another reason is that it helps you avoid any inventory write-downs or losses due to changes in market prices. Obsolete and overvalued inventories won't be a problem because you know the cost per item.
Using this method is simple, but it requires some careful record-keeping and identification. You need to assign a unique number or tag to each item you buy and keep track of its cost in your accounting system.
Then, when you sell an item, you need to find its number or tag and relieve its cost from your inventory account. You also need to record its sales price and calculate your gross profit.
Key Takeaways
- The specific identification method is a way of valuing inventory that tracks the cost of each individual item in stock.
- This method is used when the items are unique, expensive, or easily identifiable. Some examples of businesses that use this method are jewelers and art galleries. It involves keeping track of each item of inventory from the time it enters the business until it leaves.
- It assigns a specific cost to each item based on its purchase price or other identifiable features. It allows for precisely calculating the cost of goods sold, the beginning and ending inventory.
- The method avoids the effects of price fluctuations or inflation on inventory valuation. It requires a lot of record-keeping and tracking of each item in stock.
Specific Identification Method to Track Costs Example
Let us take an example.
The jewelry store owner spent $3,700 on a trio of diamond rings.
- Ring A: $1,000
- Ring B: $1,500
- Ring C: $1,200
Owned by the buyer is the jewelry store, let it be known. A few days later, you sell ring C for $2,000. How would you account for this transaction using the specific identification method? First, you would find ring C in your inventory and note its cost of $1,200.
Then, you would debit your cash account by $2,000 and credit your sales account by $2,000 to record the sale. Next, you would debit your cost of goods sold by $1,200 and credit your inventory account by $1,200 to record the cost of the ring.
To find a gross profit, apply the following formula:
Sales - Cost of Goods Sold = Gross Profit
$2,000.00 - $1,200.00
This produces a gross profit of $800.00.
Understanding the Specific Identification Method
The Specific Identification method is a way of tracking and valuing inventory that involves keeping track of each item individually. The method applies from the time it enters your business until it leaves.
By following this method, it will give you a very accurate picture of your inventory costs and profits. Better pricing, purchasing, and inventory management decisions can be made by viewing each item's exact cost and selling price.
This information provides insight into the worth of your stock to keep your business profitable. You can also avoid some of the problems that other methods can create. This can include inventory distortion or tax manipulation.
However, individually tracking every item can be labor-intensive and time-consuming. You need a system that can identify each item by a unique number or code.
In addition, you need to record its cost and sale price. This issue can be quite challenging for businesses that sell indistinguishable products with similar values or those that handle copious amounts of inventory.
Each item becomes more valuable under this method, making your inventory more prone to theft or destruction. Your business and goals will determine if this method is suitable for you.
This approach may work if your business deals with pricey, distinctive goods with varying worth and costs—like luxury trinkets, artwork, or automobiles. It can help you keep track of your inventory and profits more accurately and transparently.
But this method might not be worth the hassle if you sell cheap or common items with similar costs and values, such as books, clothes, or groceries.
Specific Identification Method Vs. FIFO
FIFO is a method of valuing your inventory based on the assumption that you sell or use the goods you bought or produced first. Assume one owns a grocery store. At this store, they may purchase 100 apples at $1 each.
Furthermore, they purchase another 100 apples at $2 each. If they sell 150 apples, the FIFO method implies that the initial 100 apples were sold at $1 each. In addition, the remaining 50 apples were sold at $2 each.
This means that your cost of goods sold (COGS) is $200 ($100 + $100), and your remaining inventory is $100 (50 apples x $2). FIFO affects how much profit you report on your income statement and how much inventory you report on your balance sheet.
Note
Other inventory valuation methods like LIFO or weighted average cost must be weighed against FIFO depending on your business and market conditions to determine their advantages and disadvantages.
One advantage of FIFO is that it matches the actual flow of goods. Sell your oldest perishable goods first if you don't want them to go bad. This applies particularly to foods and flowers.
FIFO also gives you a more accurate value of your ending inventory because it reflects the current market prices of your goods. One disadvantage of FIFO is that it can inflate your profits and taxes in an inflationary market.
If your goods' prices rise over time, FIFO will assign lower costs to your COGS and higher costs to your inventory. This means that you will report higher gross profit and net income, which sounds good, but also higher taxable income, which means more taxes to pay.
Of course, FIFO is not the only method of inventory valuation. Some businesses use LIFO, which assumes you sell or use the goods you bought or produced last. It's important to consider all options to come to a decision on which approach to use.
Different approaches may work better for different situations. This is why it's crucial to understand each one thoroughly. Ultimately, the choice will depend on the desired outcome and the resources/time available.
Your industry standards, accounting policies, tax regulations, and type of business are all factors that determine which one is appropriate.
Note
In some countries, like Canada, FIFO is the only acceptable method for tax purposes.
Like the US, other countries also have different inventory methods to choose from.
Specific Identification Method Vs. LIFO
Last in first out, or LIFO for short, is a way of valuing inventory based on the assumption that the most recent items that you bought or made are the first ones that you sell. Assuming you manage a grocery store. In the past few days, you bought apples twice.
Suppose you bought 10 for $1 each on Monday and 10 for $2 each on Tuesday. Later on, you sold 15 apples on Wednesday. Logically, you would presume that the 5 apples you sold from Monday's purchase would cost $1 each.
Furthermore, the 10 apples you sold from Tuesday's purchase would be priced at $2 each. This way, you would report a higher cost of goods sold ($25) and a lower inventory value ($5) on your balance sheet.
One reason to use this method is that it can lower your taxes when prices are rising. A lower income tax payment can be made by reporting a higher cost of goods sold, resulting in a lower net income.
Another reason is that it can accurately match your costs with your revenues. If you sell your most recent items first, you are using the costs that are closest to the current market prices. Of course, LIFO also has some drawbacks.
One is that it can distort your inventory value on your balance sheet. Some items in your inventory using the LIFO method could be outdated and low in value, not matching the current market value.
Different countries acknowledge the International Financial Reporting Standards (IFRS) do not authorize the usage of LIFO, which is one disadvantage worth mentioning.
As a result, if your business operates in several countries, you may need to opt for separate methods for differing jurisdictions. However, this process becomes simpler if your business only operates in a single country.
Example of the Specific Identification Method
Suppose you run a jewelry store, and you have three diamond rings in your inventory. Each ring has a different size, shape, and quality of the diamond, so they have different costs and selling prices.
Here's how you record them in your books:
- Ring A: Purchased on January 1 for $1,000; sold on January 15 for $1,500
- Ring B: Purchased on January 5 for $1,200; sold on January 20 for $1,800
- Ring C: Purchased on January 10 for $1,500; still in inventory at the end of January
Using the specific identification method, we can calculate the cost of goods sold (COGS) and the ending inventory value for January as follows:
COGS = Cost of Ring A + Cost of Ring B
= $1,000 + $1,200 = $2,200
Ending inventory = Cost of Ring C = $1,500
As you can see, this method requires us to keep track of each ring's cost and selling date. This way, we can match the cost of each ring with its revenue and accurately measure our gross profit. This method also reflects the physical flow of goods in and out of your inventory.
For another thing, it can be manipulated by choosing which items to sell first to achieve a desired profit level. For example, if you want to increase your profit in January, you can sell Ring B before Ring A because it has a higher markup.
Similarly, you can do the same thing if you want to reduce taxes paid on these sales this year. By selling Ring B before Ring A, your business incurs a higher cost of goods sold. This reduces taxable income, causing taxes paid to fall.
The Pros and Cons of the Specific Identification Method
Weighing the advantages and disadvantages is crucial prior to implementing this method.
This method has numerous advantages:
- It affords the most precise estimation of the cost of goods sold (COGS) and gross profit, as it considers the real cost of every sold or used item.
- It eliminates the need to make assumptions or estimates about the inventory cost flow, such as FIFO, LIFO, or weighted average methods.
- It reduces the risk of inventory write-downs or write-offs due to obsolescence, theft, or damage because you can identify and account for each item individually.
- Inventory management becomes more efficient when you can track and analyze the profitability and performance of each product or item you offer.
However, there are also disadvantages:
- Costly and time-consuming, implementing and maintaining this measure demands extensive record-keeping and tracking systems.
- The resources needed to execute it effectively are substantial.
- It is not feasible or practical for businesses that deal with large quantities of homogeneous or low-cost items, such as groceries, books, or pencils.
- It may not comply with the matching principle of accounting, which states that revenues and expenses should be recognized in the same period they are incurred.
- Inventory's market value is not always an accurate representation, given the lack of consideration for fluctuations in prices and costs.
Making decisions for your business requires weighing the pros and cons of using the specific identification method.
It may not be ideal for businesses dealing with low-cost products or high volumes, but it could work well for businesses specializing in valuable and unique items. You should also consider your industry and location's accounting standards and regulations.
Researched and authored by Haimeng Yang | LinkedIn
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