Inventory Valuation: An Overview of Costing Methods

by Craig Anthony

2 min read

One of the most impactful items in a set of financial statements relates to inventory. Accounting for inventory directly impacts assets reported on the balance sheet and cost of goods sold recorded on the income statement. These figures further affect the amount of income tax reported and the amount of net income reported. Therefore, analyze your options below and understand how each option affects your reporting.

FIFO Method

The FIFO method of inventory valuation assumes the earliest goods purchased are what is sold first — first in, first out. For example, your business buys and sells folding chairs. On January 1, you purchase 250 chairs for $100 each. On January 4, you purchase another 200 chairs of the exact make for $8 each. On January 7, you sell 50 chairs. Under the FIFO method, you sold goods that were among the first to be purchased. In this case, the cost of the 50 chairs you sold is $10 per chair. The remaining 200 chairs at $10 each and 200 chairs bought at $8 each are reported on the balance sheet as inventory.

LIFO Method

The opposite of the FIFO method is the LIFO (last in, first out) method. Using the same figures above, the sale of 50 chairs under the LIFO method would result in the last chairs bought to be sold. In this case, the cost of the chairs sold is $8. The remaining chairs — still 400 in total — are reported as 250 bought for $10 each and 150 bought at $8 each. Again, these remaining 400 chairs are reported as inventory.

Average Costing

As you purchase inventory, you may wish to simply average the price of all chairs. In this case, you spent $4,100 on the two orders that resulted in 450 chairs. The average price per chair is $9.11. Therefore, when you sell 50 chairs, the cost of these chairs is $9.11 per chair, and all remaining chairs in ending inventory have a cost of $9.11.

Impact on Financial Statements

In the examples above, the difference between the cost of goods sold under LIFO and FIFO was $2 per chair or $100 for the sale of 50 chairs. This means the cost of goods sold expense is $100 higher under FIFO. This results in net income being $100 less under FIFO, and there is now less income to report on taxes. In addition, this $100 difference is buried in the balance sheet. The cost of ending inventory under the LIFO method is $100 greater than under FIFO.

Inflation

When operating in an inflationary economy, prices of goods purchased will increase over time. Note that while this is opposite of the example above, it is most common in today’s economy. This means net income will be highest under the FIFO method because the cost of goods sold reflects the oldest prices. Meanwhile, inventory is highest under the LIFO method because the last items purchased — at the highest prices — are in inventory. During inflationary times, average costing calculations end up with cost of goods sold and inventory calculations between the numbers produced under FIFO and LIFO.

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