Question

When merchandise available for sale includes items purchased at different prices, a business must select a method of valuing the inventory and the cost of the items sold. Answer the following questions for EACH of these three methods: LIFO, FIFO, and Weighted Average.

1. What are the LIFO, FIFO, and Weighted Average inventory valuation methods? Explain briefly how each method is calculated.

2. Compare the values of ending inventory and cost of goods sold that result from using the three different methods. In times of rising prices which inventory value is higher, lower, or in between? Which one produces higher, lower, or in between cost of goods sold? Why does this happen?

3. Briefly describe the financial advantages and disadvantages of each method.

Answer 1

1.

LIFO Method:

Last-In, First-Out is one of the common techniques used in the valuation of inventory on hand at the end of a period and the cost of goods sold during the period. LIFO assumes that goods which made their way to inventory (after purchase, manufacture etc.) later are sold first and those which are manufactured or acquired early are sold last. Thus LIFO assigns the cost of newer inventory to cost of goods sold and cost of older inventory to ending inventory account. This method is exactly opposite to first-in, first-out method.

FIFO:

First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value of inventoryon hand at the end of an accounting period and the cost of goods sold during the period. This method assumes that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern.

Weighted average Method:

The weighted average method is used to assign the average cost of production to a product. Weighted average costing is commonly used in situations where:

• Inventory items are so intermingled that it is impossible to assign a specific cost to an individual unit.
• The accounting system is not sufficiently sophisticated to track FIFO or LIFO inventory layers.
• Inventory items are so commoditized (i.e., identical to each other) that there is no way to assign a cost to an individual unit.

When using the weighted average method, divide the cost of goods available for sale by the number of units available for sale, which yields the weighted-average cost per unit. In this calculation, the cost of goods available for sale is the sum of beginning inventory and net purchases. You then use this weighted-average figure to assign a cost to both ending inventory and the cost of goods sold.

2. Example:

Q-

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 and calculate the value of inventory using each method?

Units will be 1200+500-700=1000 lolypoop in unit

a) under FIFO Calculation

b)Under LIFO

c) Under Weighted Average

3.

a)

Advantages and disadvantages of FIFO The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value. All the advantages of FIFO occur because when a company sells goods, the first costs it removes from inventory are the oldest unit costs. A company cannot manipulate income by choosing which unit to ship because the cost of a unit sold is not determined by a serial number. Instead, the cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income.

The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for tax purposes in periods of inflation. We discuss these disadvantages later as advantages of LIFO.

b)Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that prices have risen almost constantly for decades. LIFO supporters claim this upward trend in prices leads to inventory, or paper, profits if the FIFO method is used. During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income.

The first criticism—that LIFO matches the cost of goods not sold against revenues

The second criticism—that LIFO grossly understates inventory

The third criticism—that LIFO permits income manipulation.

c)

Advantages and disadvantages of weighted-average When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with the actual physical flow of goods. For example, fresh meats and dairy products must flow in a FIFO manner to avoid spoilage losses. In contrast, firms use coal stacked in a pile in a LIFO manner because the newest units purchased are unloaded on top of the pile and sold first. Gasoline held in a tank is a good example of an inventory that has an average physical flow. As the tank is refilled, the new gasoline mixes with the old. Thus, any amount used is a blend of the old gas with the new.

Although physical flows are sometimes cited as support for an inventory method, accountants now recognize that an inventory method’s assumed cost flows need not necessarily correspond with the actual physical flow of the goods. In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on other criteria.