Question

Assume you are trying to explain the different methods to value inventory to a family member that is self-employed and knows nothing about accounting.

Her comment to you is: "The cost of inventory can only be one number. How can you suggest it can be one of 4 different numbers. Sounds like you are cooking the books to me."

Please explain Why in accounting, there are different methods to value inventory.

Answer 1

For one, accounting principles across the globe are quite varied. Businesses registered in the United States follow the Generally Accepted Accounting Principles (GAAP) while those in most other countries follow the International Financial Reporting Standards or IFRS for short.

There are three most common methods that retailers use:

• First-In-First-Out (FIFO)
• Last-In-First-Out (LIFO)
• Weighted Average Cost (WAC)
• First-In-First-OutMethod(FIFO)

• In this method, you assume that the first products to enter the inventory are also the first ones to be sold. You always sell your oldest inventory first. The obvious benefit of this method is that it accurately reflects how most retailers do business.

  FIFO Example

  For example, you may be a retailer of men’s clothes. In January 2019, you order 40 pants of a specific type for $10 each from your vendor. In February, order the same 40 pants but at $15 each. So, if you sell 30 shirts, the cost of goods in this method would be $300.

  Cost of Goods Sold = Quantity (30) X FIFO cost ($10) = $300

  If instead, you sell 50 pants, your new cost of goods sold would be as follows:

  Cost of Goods Sold = [Quantity 1 (40) X FIFO cost 1 ($10)] + [Quantity 2 (50-40=10) X FIFO Cost 2 ($15)] = $550

  You will continue to calculate the cost of goods in this manner for the given financial year.

  Last-In-First-Out Method (LIFO)

  In this method, the end result of calculations is the exact opposite of what it is in FIFO. You assume that the last products to enter your inventory are the first ones to be sold.

  LIFO Example

  For the same example above, your LIFO calculations would look like this:

  For 30 products:

  Cost Of Goods Sold = Quantity (30) X LIFO Cost ($15) = $450

  Likewise, had you sold fifty products, the calculation would be

  Cost of Goods Sold = [Quantity 1 (40) X LIFO cost 1 ($15)] + [Quantity 2 (50-40=10) X LIFO Cost 2 ($10)] = $700

  In LIFO, the net income would be the lowest possible number to report, since the latest, most expensive costs are used first. LIFO is used because it keeps taxable income to a minimum. However, your reported profits would also be lower. Moreover, as discussed earlier, LIFO is only accepted under US GAAP rules. If you choose to expand operations to other countries, you’re signing up for accounting problems with LIFO.

  Weighted Average Cost (WAC)

  Because both FIFO and LIFO deal with extreme case scenarios, it is important to have a system that balances out the pitfalls of both. Enter, Weighted Average Cost or WAC. This method is useful if your business does not have too much variation in inventory levels.

  Weighted Average Cost Example

  Let us continue with the same example. You added a total of 80 pants to your inventory, of which you paid $10 per product for 40 of them and $15 per product for the rest. You would calculate the WAC cost as

  Cost of Goods Sold (per item)= {[Cost 1 X Quantity 1] + [Cost 2 X Quantity 2]} / Total quantity

  In this example

  Cost of Goods Sold (per item) = {[10 X 40] + [15 X 40]}/ 80 = $12.5

  Irrespective of which order you sell the product in, for that time period, you will always account for the cost of goods as $12.5 per product.

  In general, given how different the results produced by each method are, you should carefully consider what benefits outweigh which pitfall. A certified accountant is the right person to guide you on choosing the best inventory valuation method for your business.