The FIFO and LIFO accounting methods as well as the Weighted Average Cost method are three methods used when accounting for inventory.
As you'll see below, each of these three methods result in different values for your inventory at the end of the accounting period as well as your cost of goods sold.
In this lesson we're going to look at all three methods with examples.
Inventory Valuation and Tracking
Businesses need to keep track of which items they sell and which items they have on hand, including their exact value.
During the year your inventory on hand is valued at how much it cost you to buy it (or if you're a manufacturing business - to make it). Each time you receive inventory you simply record how much it cost and enter it in your accounting system.
Now, there are two broad categories of accounting systems for inventory - you can use the periodic or perpetual system to track your inventory.
With the perpetual system, you keep perpetual (constant) track of how much inventory you have on hand and exactly how much they're worth. This is the case with computerized systems, systems involving barcode scanning, etc.
With the periodic system of accounting one knows how many goods and what their values are only at certain points in time. One does not keep constant track of them. This is the case where one just keeps simple inventory records and does a periodic (occasional) physical stock count.
When using the periodic system, at the end of each period (month or year) one should always do a physical inventory count to determine the number of inventory on hand (actually, this should also be done for a perpetual system - in this case to just confirm the quantity of inventory shown on your computerized inventory system).
With a perpetual inventory system you'll be able to tell the value of the goods on hand by simply getting this data from your computerized accounting system.
But with a periodic system, you need to actually place a value on the goods you have in stock.
One would think this would be easy - the value of the goods is simply how much they originally cost. Unfortunately there is a bit more to it than just this.
For example, how do you know that the goods you have on hand on the 31st of December are the ones you bought in October, or the ones you bought in September, or the ones you bought earlier in the year?
What happens if all your inventory looks the same, but they cost different amounts at different points in the year? How do you know which ones you sold, and which ones you have on hand right now?
There are three inventory accounting methods used to calculate the value of the goods you have on hand at the end of the period as well as the cost of the goods that you sold.
An Example to Illustrate the Three Inventory Accounting Methods
The following example will illustrate these three methods:
Cindy Sheppard runs a candy shop. She enters into the following transactions during July:
July 1 Purchases 1,200 lollypops at $1 each. July 13 Purchases 500 lollypops at $1.20 each. July 14 Sells 700 lollypops at $2 each.
First of all, how many lollypops does she have at the end of the month?
Answer: 1,200 + 500 – 700 = 1,000 lollypops
Now, there are three ways that Ms. Sheppard could value her closing stock:
1. The FIFO Method
The FIFO method is the first option for valuing stock and probably the most common.
What Does FIFO Stand For?
FIFO stands for First In First Out.
What Does FIFO Mean for Valuing Inventory?
The FIFO method assumes that the first inventories boughtare the first ones to be sold, and that inventories bought later are sold later.
Applying the FIFO Method to Our Example
Using our example above and the FIFO method, the value of our closing inventories would be calculated as follows:
Using the First-In-First-Out method, our closing inventory comes to $1,100.
This equates to a cost of $1.10 per lollypop ($1,100/1,000 lollypops).
Where Do We Normally Find the FIFO Method Used?
It is very common to use the FIFO method if one trades in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date.
Thus the first-in-first-out method is probably the most commonly-used method for small businesses.
2. The LIFO Method
Another method that is used, and the opposite of the FIFO method, is LIFO.
What Does LIFO Stand For?
LIFO stands for Last In, First Out.
What Does LIFO Mean for Valuing Inventory?
The LIFO method assumes that the last inventories bought (the most recent) are the first ones to be sold, and that inventories bought first (the oldest ones)are sold last.
Applying the LIFO Method
The value of our closing inventories from our example would be calculated as follows using the LIFO method:
Using the Last-In-First-Out method, our closing inventory comes to $1,000.
This equates to a cost of $1.00 per lollypop ($1,000/1,000 lollypops).
Where is the LIFO Method Used?
The LIFO method is commonly used in the USA.
It is generally not used outside the US.
3. The Weighted Average Method
The weighted average method is a final option for valuing our inventory.
What Does the Weighted Average Method Mean for Valuing Inventory?
This method assumes that we sell all our inventories simultaneously.
The weighted average method specifically involves working out an average cost per unit at each point in time after a purchase.
Applying the Weighted Average Method
Using the example above, the value of our closing inventories would be calculated as follows:
Using the weighted average cost method, our closing inventory amounts to $1,059.
This equates to a cost of $1.06 per lollypop ($1,059/1,000 lollypops).
Where is the Weighted Average Method Used?
The weighted average cost method is most commonly used in manufacturing businesses where inventories are piled or mixed together and cannot be separated or differentiated from each other, such as with chemicals or oils.
For example, chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together.
So we just work out a weighted average cost for all the chemicals we have in our possession.
FIFO vs LIFO vs Weighted Average Around the World
Generally accepted accounting principles in the United States allow for the use of all three inventory methods.
However, the LIFO method is the preferred inventory valuation method in the US.
At the same time, the LIFO method is disallowed in non-US countries (it is disallowed under International Financial Reporting Standards, which are the accounting standards that most of the world uses).
The FIFO method and the weighted average cost method are used in non-US countries.
In recent years there have been calls for the standardization of accounting rules throughout the world and there has been talk specifically about disallowing LIFO in the US (or making the rest of the world follow the LIFO system, which is probably unlikely to occur).
Anyway, as of this writing the matter has not yet been resolved and so the differences in inventory valuation still exist.
Well, that's it for our lesson on FIFO and LIFO accounting and the weighted average method. We hope these inventory accounting methods are a bit clearer now!
In our next lesson we're going to take a look at Cost of Goods Sold, the key expense for businesses that have inventory, and we'll see how FIFO, LIFO and the average method affect the cost of goods sold expense and the profit figures for a trading business.
We'll also look at the cost of goods sold formula, an equation which has left many an accounting student and practitioner somewhat confused, or at a minimum, having to resort to outright parroting. Our simple explanations of this formula should make it much easier to remember.