subject: Inventory Methods for Accounting [print this page] In accounting, listing the precise inventory for a company is vital for the company's success. Inventory is an asset that is anticipated to be eventually sold. Listing the accurate amounts of inventory is crucial for a company to profit and maintain stable inventories. Inventories are usually one of the largest components of assets listed under a company's balance sheet. Investors look to evaluate the companies inventories, often times a huge decision in which business to invest. Deciding which method to use to calculate inventory depends on the firm and sector of their business. Under Generally Accepted Accounting Principles (GAAP) there are a wide variety ways to calculate inventory. There are two main systems that can be used to obtain information about Cost of Goods Sold. One system is known as the perpetual inventory system, and the other periodic inventory system. Each system uses the three most commonly used approaches for inventory valuation methods: First-in, first-Out (FIFO), last-in, first-Out (LIFO), and weighted average. With a variety of options, and a diverse global market some options are more beneficial than others.
First-in first-out (FIFO) is a method that infers that the inventory is sold in the order that they are purchased. When the sale occurs the costs of goods sold come from the most recently purchased supplies. For example say a company had a beginning inventory of 20 tables @ $10 each on August 1st, and then bought 20 more tables on August 5th @ $8 each. The following week a customer wants 10 tables. The company's cost of goods sold would be the tables they first bought from August 1st @ $10 each= $100, leaving them with the inventory balance of 10 tables @ $10 each and 20 tables @ $8 each. Many manufacturing corporations use FIFO because it values the cost of goods sold most closely to the true cost of the inventory. Another example of a company using FIFO would be a food distributer with perishable items. If they used LIFO the food would not be distributable because it would perish and the company would lose money. Another benefit to using FIFO is during times of high inflation. Usually the FIFO method has lower costs of goods sold, which gives the company a higher net income, however higher net income leads to higher taxes. When using FIFO the end of the year the inventory usually consists of supplies most recently purchased.
Last-in, first-out, opposite of FIFO assumes that most recent purchases are sold first. One main benefit of LIFO is that because it uses costs from most recent purchases, it comes closest to equaling cost of goods sold with the company's revenue. For example if the company had the same costs, supplies, and customer as earlier, the company would sell the 10 tables @ $8 each because they were the supplies most recently purchased. Therefore the cost of goods sold would be $10 @ $8 = 80 instead of the $100 (COGS) using FIFO. A disadvantage of using LIFO is that there could potentially be old inventory, which could be archaic. However, LIFO is one of the most eminent tactics a company can use as a tax deferral when prices are increasing. Many companies choose LIFO just for that reason alone.
The last most commonly used method to calculate inventory is weighted average. Weighted average, also known as average cost, measures out the total costs of the items divided by total units for sale. Weighted average really does not manipulate the inventory numbers because it's calculated using both old and new inventory. Say the same example is used, and the customer still wants 10 tables. Your total inventory is calculated (20*$10)+(20*$8)=$360. You take your total costs of items and you divide it by the total of 40 units, which gives you $9 per item ($360/40units=$9). The cost of goods sold would be $90 (10 tables*$9=$90). Weighted average is still used by corporations, however many have switched to using LIFO or FIFO because of rising costs.
Overall all three of these methods are commonly practiced among accountants. With changing times in society, and rising costs some seem more affective and practical than others. Also with inflation during certain economic times threatening business, LIFO and FIFO have seemed to be used more by corporations. Each method has their own benefit, and with the United States having one of the highest corporate taxes in the world LIFO has been gaining popularity in corporate America. FIFO has been popular among companies, especially manufacturing firms because it closely resembles the true cost of inventory, and does not allow items to become too old and outdated costing the company money. All three of these methods give companies a variety of options, keep a precise track of inventory, and allow capitalism to thrive.
