Any products a company holds ready for sale are considered inventory. The inventory on the balance sheet is valued at the cost to the company, not at the price the company hopes to sell the product for. Companies can pick from among five different methods to track inventory, and the method they choose can significantly impact the bottom line. Following are the different inventory tracking systems:

  • First in, first out (FIFO): This system assumes that the oldest goods are sold first, and it's used when a company is concerned about spoilage or obsolescence. Food stores use FIFO because items that sit on the shelves too long spoil. Computer firms use it because their products quickly become outdated, and they need to sell the older products first.

    Assuming that older goods cost less than newer goods, FIFO makes the bottom line look better because the lowest cost is assigned to the goods sold, increasing the net profit from sales.

  • Last in, first out (LIFO): This system assumes that the newest inventory is sold first. Companies with products that don't spoil or become obsolete can use this system. The bottom line can be significantly affected if the cost of goods to be sold is continually rising. The most expensive goods that come in last are assumed to be the first sold.

    LIFO increases the cost of goods figured, which, in turn, lowers the net income from sales and decreases a company's tax liability because its profits are lower after the higher costs are subtracted. Hardware stores that sell hammers, nails, screws, and other items that have been the same for years and won't spoil are good candidates for LIFO.

  • Average costing: This system reflects the cost of inventory most accurately and gives a company a good view of its inventory's cost trends. As the company receives each new shipment of inventory, it calculates an average cost for each product by adding in the new inventory.

    If the firm frequently faces inventory prices that go up and down, average costing can help level out the peaks and valleys of inventory costs throughout the year. Because the price of gasoline rises and falls almost every day, gas stations usually use this type of system.

  • Specific identification: This system tracks the actual cost of each individual piece of inventory. Companies that sell big-ticket items or items with differing accessories or upgrades (such as cars) commonly use this system. For example, each car that comes onto the lot has a different set of features, so the price of each car differs.

  • Lower of cost or market (LCM): This system sets the value of inventory based on which is lower — the actual cost of the products on hand or the current market value. Companies that sell products with market values that fluctuate significantly use this system. For instance, a brokerage house that sells marketable securities may use this system.

You usually find some information on the type of inventory system a company uses in the notes to the financial statements. Any significant detail about inventory costs appears in the notes section or in the management's discussion and analysis section.

After a company chooses a type of inventory system, it must use that system for the rest of its corporate life unless it files special explanations with its tax returns to explain the reasons for changing systems. Because the way companies track inventory costs can have a significant impact on the net income and the amount of taxes due, the IRS closely monitors any changes in inventory tracking methods.