Question

Explain the advantages and disadvantages of the four major inventory costing methods.

Answer 1

1) FIFO

Advantages:

-- FIFO saves time and money in computation of the exact inventory cost being sold because the cost would be depending upon the most former cash flows of purchases to be initially used.

-- It is based on an easy and simple concept which is easy to understand.

-- FIFO IS widely accepted and used approach of valuation which increases its consistency and comparability

-- The method will depict increased gross and net profits in times of rising prices

-- As in FIFO policy there remains no vagueness for the values to be used in cost of sales profit/loss statement figure thus it makes the manipulation difficult in financial statements

Disadvantages:

-- In the times of inflation FIFO method results in higher profits, thus causes higher tax liabilities

-- The method would not be an appropriate measure when goods/ materials purchased have fluctuating patterns in pricing, because it can result to misstated profits for the same period as different costing of same product during that same period are considered.

-- FIFO would not be suitable method in times of “hyper inflation”. During this period there exist no reasonable inflation pattern and goods prices could inflate drastically

2) LIFO:

Advantages:

--LIFO gives a better measurement of current earnings with the matching the recent costs against current revenues

-- LIFO alleviate the overstatement of profit thus provides an improvement in cash flows.

-- With LIFO method the latest costs are moved to cost of goods sold and then this expense is more demonstrator of current prices. These costs are high during inflation thus the resulting gross profit and net income are lower. It helps the company to save tax dollars since payments are reduced

-- This method is less likely to be affected with the fall in price in future, thus minimizes write-downs to market

Disadvantages:

-- During the inflationary times LIFO reduces the earnings

-- An entity company applying this method can manipulate easily its reported earnings for a period with the change in its purchase pattern at the end of the year.

-- LIFO is based on the oldest costs and as a result the inventory figure is usually understated

-- LIFO liquidation can inflate the reported income for a specified period that results in higher payments of taxes for the period.

3) Weighted average method

Advantages:

-- This method minimizes the effect of unusual low and high prices of material.

-- The method is suitable and practical for charging cost of material used in the process of production.

-- The weighted average method is useful for managers for analyzing of operating results.

-- It is simple to apply this method when the receipts of material are not numerous.

Disadvantages:

-- Under this method the materials utilized may not be charged to production at the current price.

-- When there are numerous receipts many calculations are required.

-- The cost charged on the production would not be the actual prices.

4) Specific identification method

Advantages:

-- Specific identification method assists the organisation in keeping the track of each and every inventory item used in the business from the time the inventory comes in the entity till the time it goes out of the entity.

-- It provides a high degree accuracy in the closing stock valuation at the end of the specific period and in the cost of the goods sold valuation during the period

Disadvantages:

-- The company's net income can be manipulated easily by the company's management.

-- If there are huge number of transactions in company, it becomes difficult to clearly identify the products purchased, thus the method is restricted and is rarely used to the businesses dealing in high-value items