Inventory is the largest current asset of any business. So it is necessary to use a valid method to assign a cost to the inventory. There are three basic inventory valuation methods including FIFO, LIFO and weighted average method. These three methods give different cost of ending inventory, cost of goods sold gross profit. Some will give you the highest cost of goods sold, lower ending inventory and lower gross profit. Other result in lower cost of goods sold, highest ending inventory and highest gross profit.
1. First in First out Method (FIFO)
Under FIFO method, items that
are first bought are first sold. FIFO is the most widely used method for
inventory valuation. This method is generally used by those firms dealing in
perishable items. In the environment of rising prices, the FIFO method is
preferred. If the prices of goods go up, the FIFO method will give you the
lower cost of goods sold because it is based on cheaper, older cost. This result
more gross profit and a higher taxable income. The first in first out (FIFO)
method can be applied to both the periodic inventory system and the perpetual
inventory system.
Example:
Find cost of ending inventory,
cost of goods sold and gross profit using FIFO method under periodic system.
The data is given below:
Computation for
ending units:
Opening units 100
Total purchased units 700
Units available for sale 800
Total sold units 400
Ending units 400
Computation for
cost of ending inventory:
Computation for
cost of goods sold:
Opening inventory 2000
Purchases 17500
Cost of goods available for sale 19500
Ending inventory 10000
Cost of goods sold 9500
Computation for
gross profit:
Sale 12000
Cost of goods sold 9500
Gross profit 2500
2. Last in First out Method (LIFO)
Under LIFO method, the items
that are bought last are sold first, so the items remaining in stock are the
oldest. As such this method does not
follow most companies’ natural inventory flow, in fact, the method is banned by
International Financial Reporting Standards (IFRS). The LIFO method is opposite
the FIFO method. When prices of goods increase under LIFO method, the cost of
goods sold is relatively higher and the cost of inventory is relatively lower
and net income is also lower. This result fewer income tax to pay.
Example:
Find cost of ending inventory,
cost of goods sold and gross profit using LIFO method under periodic system. Take
data from the above table:
Computation for
cost of ending inventory:
Computation for cost of goods sold:
Opening inventory 2000
Purchases 17500
Cost of goods available for sale 19500
Ending inventory 9500
Cost of goods sold 10000
Computation for gross profit:
Sale 12000
Cost of goods sold 10000
Gross profit 2000
3. Weighted Average Method
The weighted average method
relies on average per unit cost. The cost of ending inventory and the cost of
goods sold is calculated using average per unit cost. The average per unit cost
is determined by dividing the total cost of units available for sale by total
number of units available for sale. The weighted average method is used by
those companies using periodic inventory system. While on the other hand,
companies using perpetual inventory system use moving average method. Under the
moving average method, a new average per unit cost is determined every time a
purchase is made.
Example:
Find cost of ending inventory,
cost of goods sold and gross profit using weighted average method under
periodic system. Take data from the above table:
Computation for
cost of ending inventory:
Step 1:
Per unit average cost = cost of units available for sale
/ Total units available for sale
Per unit average cost = 19500 / 800
Per unit average cost = 24.375
Step 2:
Cost of ending inventory = Per unit average cost x Ending
units
Cost of ending inventory = 24.375 x 400
Cost of ending inventory = 9750
Computation for cost of goods sold:
Opening inventory 2000
Purchases 17500
Cost of goods available for sale 19500
Ending inventory 9750
Cost of goods sold 9750
Computation for gross profit:
Sale 12000
Cost of goods sold 9750
Gross profit 2250
The generally Accepted Accounting Principles allow these three inventory valuation methods to be used.
However, the International Financial Reporting Standards (IFRS) does not allow
LIFO to be used.
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