Question

In your own words, describe FIFO, LIFO, Weighted Average, and Lower of cost or market inventory valuations.Next pick two different companies in the same type of industry using two different inventory valuation methods and compare them. Examples of questions to be thinking about are: Why would one company use one method over another? How does the inventory method effect the net income/loss and COGS? What would happen if the companies changed their method of valuation?

Answer 1

Answer :

FIFO description:

FIFO Stands for First-In, First-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold, In other words, the cost associated with the inventory that was purchased first is the cost expensed first.

LIFO description:

LIFO stands for Last-in, First-out, meaning that the newest inventory items are recorded as sold first, using LIFO, the last cost of goods are recognized as cost first,leaving the oldest cost in the value of inventory,this is not generally a suitable method of stock valuation because, it does not reflect normal practice in which the old stock is used first.

Weighted Average:

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as WAVCOs. It takes Cost of Goods Available for Sale and divides it by the number of units available for sale (number of goods from Beginning Inventory + Purchases/production). This gives a Weighted Average Cost per Unit.

Lower of Cost or Market:

Lower of cost or market (LCM or LOCOM) is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value, and thus the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to "Cost of goods sold" (COGS) if non-material, or "Loss on the reduction of inventory to LCM" if material.

FIFO method example:

Let’s say Company X bought shirts on two separate occasions at two different prices during a month:

1000 shirts at $100

2000 shirts at $200

At the end of the month, the business had sold 500 shirts.

With FIFO, we use the costing from our first transaction when we purchased 1000 shirts at $100 each.

So, after selling 500 shirts:

COGS = (500 shirts x $100 FIFO cost) = $50000

50 shirts from the first purchase are still left on the shelves, costed at $100 each, as well as the remaining 2000 shirts from the second purchase at $200 each. So:

Remaining inventory value = (500 shirts x $100 cost) + (2000 shirts at $200 cost) = $450000

LIFO method example:

Using the example above, Company Y uses the LIFO method , the cost from the latest transaction when 2000 shirts were purchased at $200 each.

After selling 500 shirts:

COGS = (500 shirts x $200 LIFO cost) = $100000

The 1000 shirts that we bought in the first purchase are still left at $100 each. We also have 1500 shirts from the second purchase at $200 each. So:

Remaining inventory value = (1000 shirts at $100 cost) + (1500 shirts at $200 cost) = $400000

Explanation:

No differences would occur if purchase prices were constant. Since a company’s purchase prices are seldom constant, inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore, companies must disclose on their financial statements which inventory costing methods were used.

The inventory method a company uses affects its costs of goods sold, or COGS, which has an impact on its profitability ratios. The formula for COGS is beginning inventory plus purchases less ending inventory. A company using FIFO to value its inventory reports lower COGS, which increases its gross profit margin (sales less COGS) and its net income all else being equal. Higher net income means higher profit margin. A company using LIFO reports higher COGS, translating into lower gross profit, net income and profit margins. This means earnings per share (net income divided by equity shares outstanding) is higher using FIFO all else being equal