Question

If inventory is being valued at cost and the price level is steadily rising, which of the following three methods of costing—FIFO, LIFO, or weighted average cost—will yield the lowest annual after tax net income? Which method will yield the highest after tax net income in a scenario where the price level is steadily declining? Which of the three methods of inventory will in general yield an inventory cost most nearly approximating current replacement cost?

Answer 1

First-in-First-Out Method (FIFO)

According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most widely used method for inventory valuation. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced.

Last-in-First-Out Method (LIFO)

This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.

Average Cost Method (AVCO)

Under average cost method, weighted average cost per unit is calculated for the entire inventory on hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as follows:

Weighted Average Cost Per Unit= Total Cost of Goods in Inventory
Total Units in Inventory

The weighted average cost as calculated above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.