Question

Identify the differences between F.I.F.O., L.I.F.O., and the average-cost method of inventory valuation.

Be sure to include the effects of each method on cost of goods sold and net income in your answer.

Discuss the differences between the physical movement of goods and cost flow assumptions.

Your answer should illustrate understanding of the three major inventory valuation methods, and the relationship between physical inventory flow and cost flow assumptions.

Answer 1

The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows. The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost.

• First-In, First-Out (FIFO): This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on the balance sheet).
• Last-In, First-Out (LIFO): This method assumes that the last unit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
• Average Cost: This method is quite straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.25 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.

• Consider this example: Say you’re a furniture store and you purchase 200 chairs for $10/unit. The next month, you buy another 300 chairs for $20 each. At the end of an accounting period, assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:
• Example: 200 chairs @ $10 = $2,000. 300 chairs @ $20 = $6,000. Total number of chairs = 500
• Weighted Average Cost: Cost of a chair: $8,000 divided by 500 = $16/chair. Cost of Goods Sold: $16 x 100 = $1,600. Remaining Inventory: $16 x 400 = $6,400
• FIFO: Cost of goods sold: 100 chairs sold x $10 = $1,000. Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000
• LIFO: Cost of goods sold: 100 chairs sold x $20 = $2,000. Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000

KEY TAKEAWAYS

• The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
• The FIFO accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time.
• The LIFO accounting method assumes that the latest items bought are the first items to be sold.

The Role of Inflation in Valuing Inventory

If inflation were nonexistent, then all three of the inventory valuation methods would produce the same exact results. When prices are stable, our bakery would be able to produce all of its bread loaves at $1, and LIFO, FIFO, and average cost would give us a cost of $1 per loaf. But prices do tend to rise over the long term, which means that the choice of accounting method can dramatically affect valuations.

LIFO and FIFO adjusted for inflation

Assuming that prices are rising, the three valuation methods would behave as follows:

• LIFO is not a good indicator of ending inventory value because the leftover inventory might be extremely old, perhaps obsolete, which results in a valuation much lower than today's prices. The LIFO method results in less net income because COGS is greater.
• FIFO gives us a good indication of ending inventory value, but it also increases net income because inventory that might be several years old is used to value COGS. And although increasing net income sounds good, remember that it also has the potential to increase the amount of taxes that a company must pay.
• Average cost produces results that fall somewhere between FIFO and LIFO.

Note that if, instead of increasing, prices are decreasing, then the complete opposite of the above is true.

In addition, many companies will state that they use the "lower of cost or market" when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO, or average cost.

Example—ABC Bottling Company

In the tables below, we use the inventory of a fictitious beverage producer to see how the valuation methods can affect the outcome of a company’s financial analysis.

We start with the assumption that ABC has a beginning inventory of 4,000 units—1,000 units purchased at $8 each = $8,000.

Then, for all calculations we assume that there are 1,000 units left for ending inventory—4,000 units - 3,000 units sold = 1,000 units.

ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCH

ABC CO. — MONTHLY INVENTORY PURCHASES
Month	Units Purchased	Cost / Each	Value
Jan	1,000	$10	$10,000
Feb	1,000	$12	$12,000
Mar	1,000	$15	$15,000
	3,000 = Total Purchased
Item		LIFO	FIFO	Average Cost
Sales = 3,000 units @ $20 each		$60,000	$60,000	$60,000
Beginning Inventory		8,000	8,000	8,000
Purchases		37,000	37,000	37,000
Ending Inventory		8,000	15,000	11,250
COGS		$37,000	$30,000	$33,750
Expenses		10,000	10,000	10,000
Net Income		$13,000	$20,000	$16,250

Here are the inventory results based on our three GAAP methods:

• Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that the last units in (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
• Ending Inventory per FIFO: 1,000 units x $15 each = $15,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
• Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit; 1,000 units X $11.25 each = $11,250. Remember that we take a weighted average of all the units in inventory.

LIFO or FIFO? It Really Does Matter

The difference between $8,000, $15,000 and $11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics—factors that expose a company's current financial health, and which enable us to make projections about its future, for example. So, which inventory figure a company starts with when valuing its inventory really does matter. And companies are required by law to state which accounting method they used in their published financials.

Although the ABC Company example above is simple, the subject of inventory and whether to use LIFO, FIFO, or average cost is complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage can prevent a company from operating efficiently.