Question

The management of Bluetree Ltd, a company in manufacturing, would like to change the accounting policy of valuing inventory from FIFO to Weighted average. There was a steady increase in the material prices for the past financial year. Advise management what the most likely effect will be on the financial statements, use examples if needbe   

Answer 1

If company changes its inventory valuation method from FIFO to weighted average method then it is basically changing the principle of valuation as FIFO follows a particular cost flow assumption whereas weighted average method uses weighted average of the cost at which inventory was held at the beginning of the period and cost of the goods bought during the period. So, both methods use different basis to value the closing inventory.

Example

Consider this example: Suppose you own a furniture store and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let's assume you sold 100 total chairs.

200 chairs at $10 per chair = $2,000. 300 chairs at $20 per chair = $6,000

Total number of chairs = 500

Weighted Average Cost

Cost of a chair: $8,000 divided by 500 = $16/chair

Cost of Goods Sold: $16 x 100 = $1,600

Remaining Inventory: $16 x 400 = $6,400

First In, First Out Cost

Cost of goods sold: 100 chairs sold x $10 = $1,000.

Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

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