Many accounting principles are taught, but there is no reason specified for why you are supposed to account this way. It is the method you are taught and you go along with it. In my personal experience, inventory accounting techniques were one of these principles that was taught but never explained. Throughout the course of this paper, I will explain why inventory count and techniques are important, explain three inventory techniques, and describe how to use them.
When you own a business, knowing how much inventory you have is crucial. How else are you supposed to know if you have a surplus or shortage of goods. What is even more crucial is the way that you account for this inventory as it leaves your possession. Especially in today's market, prices fluctuate rapidly. The item that came into your store a month ago probably does not cost the same as the identical product that came in yesterday. With a warehouse full of the same item, how do you differentiate between the products cost? How do you calculate what your profit off an item is if you do not know the original cost? Which numbers do you report to the IRS if you have several different costs of goods sold? This is all where inventory counts come in. That is why there is a system and regulations to follow when regarding inventory.
The first technique is FIFO, short for "first in, first out". In this technique, the oldest good in inventory is the next one to be sold. When referring to a good being sold, I'm not talking about a specific good being sold, but instead the monetary value attached to that good. The second technique is, LIFO, short for "last in, first out". This is the opposite of FIFO, with the last item checked into inventory being the first item to be sold. The third technique is weighted average. This technique does not give each individual good a price, but the good as a whole a price. In weighted average, each good, on paper, cost the company the same.
Now I will describe how to use each technique, starting with FIFO. Consider that at the beginning of the month you have 10 items purchased for $2.00 each. Then you get another shipment of 10 items at $2.50 each. To keep things simple, imagine these 20 items are the only ones you have in inventory. At the end of the month, you have sold 12 items. Using the FIFO technique, all 10 items purchased for $2.00 are sold because those were the oldest items in inventory. Then the two extra goods sold are accounted from the inventory received next. This would make the cost of goods sold $25.00. Now you would have eight items in inventory costing $2.50 each, for a total inventory of $20.00.
Using the same example, I will show LIFO used. At the end of the month, you again sell 12 items. This time, however, the ten items purchased this month will be the first ones sold. The remaining two items will come from the beginning inventory. Now the cost of goods sold is $29.00. The remaining inventory costs $16.00 on the books. Using this technique, as long as your inventory never gets to zero, the first items you bought will always be accounted in inventory.
The final technique I will discuss is Weighted Average. Using this technique, each good is assigned the same value, the average cost of good. To get the weighted average, the simplest way is to multiply the unit cost by the amount of units purchased for that amount. Do this for all different unit costs in the inventory. This will give you the amount you paid for all inventory in stock. Then divide this number by the amount of units in inventory. This is the weighted average. Now at the end of the month when you are calculating cost of goods sold, each good sold is recorded at this price. Using the previous example, the weighted average of the inventory would be $2.25 ( (10 x $2.00 + 10 x $2.50) / 20). Each of the twelve items sold would be marked as costing the company $2.25, totaling $27.00. The remaining inventory is equal to $18.00.
As you can see, the three different techniques used have brought different totals for cost of goods sold and inventory remaining, but if all the inventory was sold, the outcome would be equal among the different techniques.
When you own a business, knowing how much inventory you have is crucial. How else are you supposed to know if you have a surplus or shortage of goods. What is even more crucial is the way that you account for this inventory as it leaves your possession. Especially in today's market, prices fluctuate rapidly. The item that came into your store a month ago probably does not cost the same as the identical product that came in yesterday. With a warehouse full of the same item, how do you differentiate between the products cost? How do you calculate what your profit off an item is if you do not know the original cost? Which numbers do you report to the IRS if you have several different costs of goods sold? This is all where inventory counts come in. That is why there is a system and regulations to follow when regarding inventory.
The first technique is FIFO, short for "first in, first out". In this technique, the oldest good in inventory is the next one to be sold. When referring to a good being sold, I'm not talking about a specific good being sold, but instead the monetary value attached to that good. The second technique is, LIFO, short for "last in, first out". This is the opposite of FIFO, with the last item checked into inventory being the first item to be sold. The third technique is weighted average. This technique does not give each individual good a price, but the good as a whole a price. In weighted average, each good, on paper, cost the company the same.
Now I will describe how to use each technique, starting with FIFO. Consider that at the beginning of the month you have 10 items purchased for $2.00 each. Then you get another shipment of 10 items at $2.50 each. To keep things simple, imagine these 20 items are the only ones you have in inventory. At the end of the month, you have sold 12 items. Using the FIFO technique, all 10 items purchased for $2.00 are sold because those were the oldest items in inventory. Then the two extra goods sold are accounted from the inventory received next. This would make the cost of goods sold $25.00. Now you would have eight items in inventory costing $2.50 each, for a total inventory of $20.00.
Using the same example, I will show LIFO used. At the end of the month, you again sell 12 items. This time, however, the ten items purchased this month will be the first ones sold. The remaining two items will come from the beginning inventory. Now the cost of goods sold is $29.00. The remaining inventory costs $16.00 on the books. Using this technique, as long as your inventory never gets to zero, the first items you bought will always be accounted in inventory.
The final technique I will discuss is Weighted Average. Using this technique, each good is assigned the same value, the average cost of good. To get the weighted average, the simplest way is to multiply the unit cost by the amount of units purchased for that amount. Do this for all different unit costs in the inventory. This will give you the amount you paid for all inventory in stock. Then divide this number by the amount of units in inventory. This is the weighted average. Now at the end of the month when you are calculating cost of goods sold, each good sold is recorded at this price. Using the previous example, the weighted average of the inventory would be $2.25 ( (10 x $2.00 + 10 x $2.50) / 20). Each of the twelve items sold would be marked as costing the company $2.25, totaling $27.00. The remaining inventory is equal to $18.00.
As you can see, the three different techniques used have brought different totals for cost of goods sold and inventory remaining, but if all the inventory was sold, the outcome would be equal among the different techniques.
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