The methods of Inventory

In the business world, everyone wants to make a profit and be successful by selling a product or service

. Business firms that sell products run into the issue of how to keep track of inventory every day. There are three basic ways to keep track of inventory which are taught in introductory accounting courses in colleges all across the world. Each method serves a different purpose depending how the firm wants the information to be reflected on the balance sheet and the income statement.

The first way to keep track of inventory is called first-in, first-out (FIFO). Just as the name sounds, the first inventory that comes into the firm is the first inventory accounted for when the inventory is sold. For example, if a firm that sells t-shirts has a beginning inventory of 6 t-shirts and each one costs $1, the beginning inventory is $6 (6 t-shirts x $1). Now, if the firm purchases 6 more t-shirts at $1.50 (6 x $1.50 = $9), the total available inventory will be $15 ($6 + $9). If the firm sells 3 t-shirts, using FIFO $3 would be subtracted from the available inventory because that is included in the first group of t-shirts bought by the firm. Therefore, ending inventory would be $12 ($15 - $3). The income statement for FIFO will show the highest profit of the three ways to keep track of inventory because the cost of goods sold ($3) will be the lowest. This method is selected by firms because of the high profit it shows on the statements which makes shareholders more likely to invest in the firm.

The second way to keep track of inventory is called weighted average (WAVG). This technique finds the mean, or average, of the entire inventory regardless of when it was purchased by the company, and subtracts that value each time one unit of the inventory is sold. For example, using the same case as the above example with $6 beginning inventory and $9 more inventory purchased. Divide the available dollar amount ($15) by the available number of t-shirts (12) and come to an average cost of $1.25 per t-shirt. So, just as in the first example, if 3 t-shirts are sold, $3.75 (3 x $1.25) will be deducted from the $15 of available inventory and the ending inventory will be $11.25. The income statement for WAVG will be in the middle because it averages all costs together.

The last of the three basic ways to account for inventory is called last-in, first-out (LIFO). Again, this technique is used just as it sounds; the last inventory brought into the firm is the first to be sold. Using all of the same information as the first two problems, if the firm sells 3 t-shirts it is taken from the inventory purchased at $1.50 per shirt because that is the price of the last inventory purchased by the firm. $4.50 (3 x $1.50) will be subtracted from the available inventory for an ending inventory of $10.50 ($15 - $4.50). The income statement for LIFO will show the lowest inventory because the cost of goods sold ($4.50) generated from inventory will be the highest. This method is often chosen when inflation is high because it shows a low profit on the income statement which means taxes for the firm will be lower.

The technique chosen to keep track up inventory is completely up to each individual firm. They must keep in mind however, they are going to be taxed and how their profits will be represented in their monetary statements.

The methods of Inventory

By: Rori

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