The Inventory-Cost Connection: Four Ways to Value Inventory
There are four ways to keep track of how much your inventory is worth:
- Last in, first out (LIFO)
- First in, first out (FIFO)
- Average cost
- Specific identification
The method that works best for your business depends on what type of inventory you keep. When you offer more than one kind of product for sale, you can use a different inventory valuation method for each, because what makes sense for one may seem somewhat ridiculous for the other. This section can help you figure out which version will work best for your company.
Because different methods will give you different outcomes, prevailing accounting principles make you pick a method and stick with it. If you need to make a change, you have to have a good reason. You also may have to recalculate prior years’ numbers to show the impact of the change, and you have to stick with the new method going forward. You cannot keep switching your inventory valuation method to make your numbers come out better.
The LIFO Method
Using the LIFO method makes a lot of sense when your most current merchandise is the first to fly off the shelves. This happens with books on the bestseller list, newly released DVDs, and the latest fashions. LIFO follows that pattern, turning the most recently received inventory into the merchandise that just got sold.
When you use LIFO, your inventory system (periodic or perpetual) can make a difference in the end-of-period value of your inventory asset. Here’s why: Under a perpetual system, you track the cost of goods for every single sale, and you would use the most immediate cost at the time under LIFO. When you value the inventory only periodically, those costs are lumped together and only the most recent (at the end of the period) would be included.
LIFO is a favored valuation method among tax accountants. In periods of rising prices (and when have we really seen anything else?), the LIFO method gives you the highest cost of goods sold, and that translates into the lowest taxable income. Lower taxable income means lower income taxes, and that is what tax accountants like.
Here’s an example of how the LIFO method works, under both inventory systems: On January 1, XYZ Company bought ten units for $10 each. On January 15, it sold six of those units. On January 17, the company purchased another ten units, but this time it paid $12 each. The company sold another eight units on January 20, and bought ten additional units on January 22 for $13 each. Finally, on January 31, the company sold nine units, leaving a grand total of seven units in stock. Under the periodic inventory system, the ending inventory would have a value of $70, and the cost of goods sold would equal $280. That $280 is made up of ten units at $13 each, plus ten units at $12, plus three units at $10; you simply count up the sold units backward.
The result under perpetual inventory is different, because you calculate the cost at the time of every sale rather than once at the end. For that first sale, the cost of goods sold would be $60 (six units times $10). For the second sale, it would be $96 (eight units at $12). Then for the third sale, the cost would be $117 (nine units times $13). That would come to a grand total of $273 for cost of goods sold, and inventory would ring in at $77 at month’s end.
The FIFO Method
Inventory with a limited shelf life naturally follows the FIFO pattern. That includes things such as fresh food and flowers but can also include standard stock items such as classic movies. Under FIFO, every time you sell a product you use the earliest inventory price on the books to cost it out.
The majority of products follow this pattern, making FIFO one of the most popular inventory valuation methods. Another plus of this method is that your inventory will always be measured using the most current costs, virtually the same as its upcoming replacement value. Also, in contrast to the LIFO method, you will get the same ending inventory valuation regard- less of whether you use a periodic or perpetual system.
Here’s an example of how the FIFO method works, using a periodic inventory system: On January 10, ABC Company bought a hundred units for $20 each. By the end of the month, it had sold sixty units. Then, on February 12, the company purchased another hundred units, this time for $25 each. By the end of March, ABC Company counted thirty units still in inventory. Under the FIFO method, the cost of goods sold for the quarter (January through March) came to $3,750: a hundred units times $20 plus seventy units times $25. The company’s ending inventory was valued at $750—the remaining thirty units at $25 apiece.
Average Cost Method
The average cost method (sometimes called the weighted average cost method) works well for companies that sell a large number of very small, identical items. Think of a hardware store, with bins of nuts and bolts and nails and screws. Trying to assign a specific cost to each would just drive you crazy. It’s much easier to treat each unit as part of a whole.
The main drawback of the average cost method is the math: Every time you buy more inventory, you have to recalculate the average cost. If you use accounting software, you may not even notice that the recalculation has taken place. With a fully manual system, though, get ready to pull out your calculator.
Specific Identification
The specific identification method works well with unique or uniquely marked inventory items. A one-of-a-kind designer dress would be perfect for this method, and so would a Honda Accord with its unique vehicle identification number. Here, every time you sell a product, you remove that specific unit from inventory. Whatever you paid for that particular item now becomes the cost of goods sold number, no math, no fuss.