October 12, 2019

# Inventory Methods: FIFO, LIFO, Weighted Average Method

October 12, 2019
Inventory is the largest current asset of any business. So it is necessary to use a valid method to assign a cost to the inventory. There are three basic inventory valuation methods including FIFO, LIFO and weighted average method. These three methods give different cost of ending inventory, cost of goods sold gross profit. Some will give you the highest cost of goods sold, lower ending inventory and lower gross profit. Other result in lower cost of goods sold, highest ending inventory and highest gross profit.

## 1. First in First out Method (FIFO)

Under FIFO method, items that are first bought are first sold. FIFO is the most widely used method for inventory valuation. This method is generally used by those firms dealing in perishable items. In the environment of rising prices, the FIFO method is preferred. If the prices of goods go up, the FIFO method will give you the lower cost of goods sold because it is based on cheaper, older cost. This result more gross profit and a higher taxable income. The first in first out (FIFO) method can be applied to both the periodic inventory system and the perpetual inventory system.

Example:
Find cost of ending inventory, cost of goods sold and gross profit using FIFO method under periodic system. The data is given below:

Computation for ending units:
Opening units                            100
Total purchased units                 700
Units available for sale               800
Total sold units                          400
Ending units                              400

Computation for cost of ending inventory:

Computation for cost of goods sold:
Opening inventory                               2000
Purchases                                          17500
Cost of goods available for sale           19500
Ending inventory                               10000
Cost of goods sold                              9500

Computation for gross profit:
Sale                                              12000
Cost of goods sold                          10000
Gross profit                                     2000

## 2. Last in First out Method (LIFO)

Under LIFO method, the items that are bought last are sold first, so the items remaining in stock are the oldest.  As such this method does not follow most companies’ natural inventory flow, in fact, the method is banned by International Financial Reporting Standards (IFRS). The LIFO method is opposite the FIFO method. When prices of goods increase under LIFO method, the cost of goods sold is relatively higher and the cost of inventory is relatively lower and net income is also lower. This result fewer income tax to pay.

Example:
Find cost of ending inventory, cost of goods sold and gross profit using LIFO method under periodic system. Take data from the above table:

Computation for cost of ending inventory:

Computation for cost of goods sold:
Opening inventory                               2000
Purchases                                          17500
Cost of goods available for sale           19500
Ending inventory                                 9500
Cost of goods sold                              10000

Computation for gross profit:
Sale                                              12000
Cost of goods sold                            9500
Gross profit                                     2500

## 3. Weighted Average Method

The weighted average method relies on average per unit cost. The cost of ending inventory and the cost of goods sold is calculated using average per unit cost. The average per unit cost is determined by dividing the total cost of units available for sale by total number of units available for sale. The weighted average method is used by those companies using periodic inventory system. While on the other hand, companies using perpetual inventory system use moving average method. Under the moving average method, a new average per unit cost is determined every time a purchase is made.

Example:
Find cost of ending inventory, cost of goods sold and gross profit using weighted average method under periodic system. Take data from the above table:

Computation for cost of ending inventory:

Step 1:
Per unit average cost = cost of units available for sale / Total units available for sale

Per unit average cost = 19500 / 800

Per unit average cost = 24.375

Step 2:
Cost of ending inventory = Per unit average cost x Ending units

Cost of ending inventory = 24.375 x 400

Cost of ending inventory = 9750

Computation for cost of goods sold:
Opening inventory                               2000
Purchases                                          17500
Cost of goods available for sale           19500
Ending inventory                                 9750
Cost of goods sold                               9750

Computation for gross profit:
Sale                                              12000
Cost of goods sold                            9750
Gross profit                                      2250

The generally Accepted Accounting Principles allow these three inventory valuation methods to be used. However, the International Financial Reporting Standards (IFRS) does not allow LIFO to be used.
Share:
Older Post