The FIFO Method, LIFO Method and Weighted Average Cost

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At the end of each period (month or year) one should do a physical inventory count to determine the number of inventory on hand.

Then you need to place a value on the goods. 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.


There are three methods used when valuing the goods that you have on hand at the end of the period.

The following example will illustrate this:

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 First-In-First-Out Method (FIFO)

This method assumes that the first inventories bought are the first ones to be sold, and that inventories bought later are sold later.

The value of our closing inventories in this example 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).

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 in small business. Well, probably...

2. The Last-In-First-Out Method (LIFO)

This method assumes that the last inventories bought are the first ones to be sold, and that inventories bought first are sold last.

The value of our closing inventories in this example would be calculated as follows:

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).

The LIFO method is commonly used in the U.S.A.

3. The Weighted Average Cost Method

This method assumes that we sell all our inventories simultaneously.

The weighted average cost method is most commonly used in manufacturing businesses where inventories are piled or mixed together and cannot be differentiated, such as chemicals, oils, etc. Chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together.

So we work out an average cost for all chemicals that we have in our possession. The method specifically involves working out an average cost per unit at each point in time after a purchase.

In our example above (assuming the weighted average cost method was allowed for valuing the lollypops), 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).

Oddly enough, the LIFO method is the preferred inventory valuation method in the United States but is disallowed in non-US countries. 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 talk specifically about disallowing LIFO in the US (or making the rest of the world follow the LIFO system). As of this writing the matter has not been resolved and the differences in inventory valuation still exist.

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Next lesson: Cost of Goods Sold

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