Then you need to place a value on the goods. Companies use different methods of inventory accounting for the benefits and convenience offered by both methods in different situations. Cost of Goods Sold.
The value of our closing inventories in this example would be calculated as follows: It is very common to use the FIFO method if one trades in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date.
Thus the first-in-first-out method is probably the most commonly used method in small business. The value of our closing inventories in this example would be calculated as follows:.
The weighted average cost method is most commonly used in manufacturing businesses where inventories are piled or mixed together and cannot be differentiated, such as chemicals, oils, etc. Chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together. So we work out an average cost for all chemicals that we have in our possession. The method specifically involves working out an average cost per unit at each point in time after a purchase.
In our example above assuming the weighted average cost method was allowed for valuing the lollypops , the value of our closing inventories would be calculated as follows:. In recent years there have been calls for the standardization of accounting rules throughout the world, and talk specifically about disallowing LIFO in the US or making the rest of the world follow the LIFO system.
As of this writing the matter has not been resolved and the differences in inventory valuation still exist. Cost of Goods Sold. Click below to see questions and exercises on this same topic from other visitors to this page What would be the applied price of a stock variance in the FiFo method? What are the advantages and disadvantages of using the weighted average method?
What is the degree of accuracy of the FIFO method when using it in the balance sheet as well as the income statement? How do I find the average cost per unit of inventory using the weighted average cost method? Dear Sir, A container of goods has different quantities with different values per unit.
So the inventory will leave the stock in an order reverse of that in which it was added to the stock. It means that whenever the inventory will be reported as sold either after conversion to finished goods or as it is its cost will be taken equal to the cost of the latest inventory added to the stock. This, in turn, means that the cost of inventory sold as reported on the Profit and Loss Statement will be taken as that of the latest inventory added to the stock.
On the other hand, on the Balance Sheet, the cost of the inventory still in stock will be taken equal to the cost of the oldest inventory present in the stock.
Both these methods are purely methods of accounting for and reporting the value of inventory. Whichever method is adopted, it does not govern the actual addition or removal of inventory from the stock for further processing or selling. Another inventory cost accounting method that is also widely used by both public vs private companies is the Average Cost method.
This method takes the middle path between FIFO and LIFO by taking the weighted average of all units available in the stock during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Suppose that a company produces and sells its product in batches of units. If the inflation is positive, the cost of production will go on increasing with time. So assume that 1 batch of units is produced within each time period and the cost of production increases after each successive period.
This is summarized in the table below:. Consider the details about the three batches of production given in the above table. Suppose the batch numbers are in order of date of production of the batches. It will have to sell them as per the orders it receives and also as per the availability of the products in its stock of finished goods. So suppose that the company gets orders of a total of units after producing the 3 rd batch of units.
Now, the first units produced include the units of Batch No. Also, the value of the remaining inventory of the finished products will be equal to the cost of the remaining units in the stock i. Now, the last units produced include the units of Batch No.
The root cause why are there more than one method for the purpose of accounting for the cost of inventory is inflation. This is because if inflation is not there, the cost of material purchased today would be exactly equal to that purchased last year. So the material cost going into the production of finished goods will also come out to be the same for a particular type of products. So the cost of the inventory added to the stock today will be exactly equal to the cost of the inventory added to the stock one year ago.
Hence, whether you use LIFO method or FIFO method, the value of the inventory expensed or even that in stock will also come out to be exactly the same in any case. But since inflation is a reality, the value of inventory comes out to be something when we use FIFO and it comes out to be something else when we use LIFO.
The answer to this is this: Companies use different methods of inventory accounting for the benefits and convenience offered by both methods in different situations. So there the companies do not have that choice. And let these assumed values to be the same for both methods.
So ultimately the benefit of using the LIFO method for a company is that it can report a lower Net Income and hence defer its tax liabilities during the times of high inflation. But at the same time, it might end up disappointing the investors by reporting lower earnings per share.
On the other hand, a company which uses the FIFO method will be reporting a higher net income and hence will have a greater amount of tax liability in the near term. In addition to tax deferment, LIFO is beneficial in lowering the instances of inventory write-downs. Inventory write-downs happen if the inventory is deemed to have decreased in price below its carrying value. If LIFO is used, only old inventory will remain in stock and its purchase price will have a lesser chance of going below its carrying value.
Now, to understand the impact of both the methods on the Balance Sheet, take the values of Inventory calculated using both the methods and prepare the Balance Sheet in its simplest form assuming the values of Other Assets all assets other than the inventory and Total Liabilities to be the same for both the methods.
And let these assumed values are the same for both methods.