Inventory Accounting Methods
An Overview of the Three Most Common Inventory Valuation Methods
Aug 28, 2008
Inventories are items that a company holds for sale, or items that will be used to manufacture products that will be sold. The method that a company uses to account for its inventory determines the amount of expense recognized for cost of goods sold on the financial statement as well as the value of inventory recognized on the balance sheet. The three most commonly used methods are First-in, First Out (FIFO), Last-in, First-out (LIFO), and the average cost method.
Examples of FIFO, LIFO, and the Average Cost Method
Because identical inventory items can be acquired for different costs during the same accounting period, it is necessary to determine a unit cost using one of these cost flow assumptions. When FIFO is used, the first unit purchased is the cost of the first unit sold; therefore the ending inventory will be made up of the most recently purchased units. When LIFO is used, the last unit purchased is the cost of the first unit sold; therefore the ending inventory with this method is made up of the earliest units purchased. The average cost method is an average of all the costs; therefore the ending inventory balance is an average of the purchase costs.
An example can illustrate the difference between the three methods. A new company purchases four identical units in one month.
- 1 unit purchased on the 10th of the month at a cost of $10
- 1 unit purchased on the 16th of the month at a cost $12
- 1 unit purchased on the 20th of the month at a cost of $13
- 1 unit purchased on the 30th of the month at a cost of $14
If one item is sold for $25 using the FIFO method, the cost of goods sold would be $10, profit would be $15($25-$10), and ending inventory balance would be $39 ($12+$13+$14).
If one item were sold for $25 using the LIFO method, the cost of goods sold would be $14, profit would be $11($25-$14), and ending inventory balance would be $35($10+$12+$13).
Using the average cost method, if one item were sold for $25, the cost of goods sold would be $12.25($10+$12+$13+$14/4), profit would be $12.75, and ending inventory balance would be $36.75 (average cost per unit $12.25 x 3 remaining units).
Effects of FIFO, LIFO, and the Average Cost Method
As you can see by these examples, each method has a different effect on both profit and ending inventory values. The FIFO method has the lowest cost of goods sold, the highest profit, and the highest ending inventory balance. The LIFO method has the highest cost of goods sold, the lowest profit, and the lowest ending inventory balance. The average cost method falls in between the other two methods.
Effects of Inflation
If prices were constant during the period, all three methods would produce the exact same result since each unit would have been purchased for an identical amount. But, since prices usually change, each method will produce different results. During periods of inflation, LIFO will generate a lower amount of gross profit and a lower inventory value. The FIFO method will produce a higher gross profit and a higher ending inventory balance. During periods of inflation, LIFO offers substantial tax savings due to lower profits and lower inventories. However, in periods of deflation, the effects are just the opposite.
This is just a brief overview of some commonly used methods for valuing inventory. Inventory valuation methods have a significant impact on a company's income statement and balance sheet. Before deciding which method to use, please consult with a knowledgeable accountant or CPA. More information about these methods can be found at AICPA.org.
Additional accounting articles by Diane White- Depreciating Tangible Fixed Assets
 |
