Inventory Valuation Methods
Most companies choose one of four methods to value their ending inventory: specific identification; weighted average; first-in, first-out (FIFO); and last-in, first-out (LIFO). The amount transferring from the balance sheet inventory account to the income statement cost of goods sold can vary, depending on which method you choose. These variations are similar to the variations you get by using different depreciation methods.
The readers of the financial statements must know which inventory method the company uses. The method is always spelled out in the notes to the financial statements. If the method used is unclear, any comparison of one company’s financial statements to another will be inaccurate because the user may be comparing financial results from dissimilar valuation methods.
Understanding guidelines used for all methods
Before you dive into each inventory method, you should understand these guidelines. Each of these guidelines holds true, regardless of the inventory method you use:
Units: The number of units in beginning inventory, ending inventory, purchases, and cost of sales is the same regardless of the inventory method used. The dollar amounts for each method, however, may be different.
Total dollars: The total dollars to account for are the same for each inventory method. One method may allocate more or fewer dollars to ending inventory, for example. The total dollars representing the sum of beginning inventory, ending inventory, purchases, and cost of sales are the same.
Allocating costs: At the end of a month or year, you can post your inventory costs to only one of two places. If you sold the inventory, the cost is in cost of sales. If you didn’t sell the inventory, the cost is in ending inventory.
Keep these concepts in mind as you consider the different inventory methods.
Using the specific identification method, you can trace the exact cost of each individual item in inventory. Usually that’s because each item in inventory is unique or is equipped with a serial number that can be traced to its purchase price.
As a result, ending inventory is the total of all payments made to the particular vendors from whom the company purchases the inventoried goods less the cost of items sold. This inventory method is used for businesses with expensive individual inventory items, such as a car dealership.
For example, an art gallery selling a bronze casting by a particular artist can quickly identify how much it cost to originally purchase the casting by checking out that particular invoice from the artist. So if the gallery paid the artist $500, when the item is sold, the accounting department debits cost of goods sold for $500 and credits inventory for the same amount — reducing ending inventory by $500.
When a company uses the weighted average method, inventory and the cost of goods sold are based on the average cost of all units purchased during the period. This method is generally used when inventory is substantially the same, such as grains and fuel.
If the company sells running shoes, the total cost of all running shoes available for sale is divided by the total pairs of running shoes available for sale (total units). Multiply that figure by the number of running shoes remaining in inventory at the end of the period to get your ending inventory figure.
First-in, first-out (FIFO)
Using the FIFO method, the company assumes that the oldest items in its inventory are the ones first sold. Consider buying milk in a grocery store. The cartons or bottles with the most current expiration date are pushed ahead of the cartons that have more time before they go bad.
The oldest cartons of milk may not always actually be the first ones sold (because some people dig around looking for later expiration dates), but the business bases its numbers on the oldest cartons being sold first.
The inventory cost flow assumption states that under FIFO, the oldest units are presumed to be sold first, regardless of whether they actually are. Because prices generally increase over time (due to inflation), the oldest goods are usually the least expensive. With FIFO, you sell the oldest (and cheapest) goods first. The oldest goods aren’t always the cheapest, but you may see that trend.
Last-in, first-out (LIFO)
With this method, the company assumes that its newest items (the ones most recently purchased) are the first ones sold. Imagine a big stack of lumber in a hardware store. If a customer wants to buy a plank, for convenience’s sake, he takes one off the top.
As customers purchase the planks, more planks are added on top of the old ones instead of redistributing the old planks so they move to the top of the pile. Therefore, the newest planks are consistently sold to customers rather than the older ones.
If you again assume that prices for purchases increase over time, the LIFO method means that you sell the most recently purchased items first. Those items are generally more expensive than the older units. Again, this isn’t always true, but that’s a pattern you may see.