Inventories are items that a company holds for sale, or items that will be used to manufacture products that will be sold. The method that a company uses to account for its inventory determines the amount of expense recognized for cost of goods sold on the financial statement as well as the value of inventory recognized on the balance sheet. There are a few different ways to measure inventory in financial accounting. First, there is the method First-in, First-out, better known as FIFO. Next, there is Last-in, Last-out, or LIFO. The last two techniques are Weighted Average and Specific Identification. All four of these methods are equally efficient and can be used in measuring any inventory in financial accounting. It is equally important to know that there are two different inventory systems. The first is periodic; the Inventory account is updated or adjusted only once-at the end of the year. During the year the Inventory account will likely show only the cost of inventory at the end of the previous year. The second type of inventory system is perpetual. With perpetual inventory system, the Inventory account is continuously updated. The Inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced by the cost of merchandise that has been sold to customers.
FIFO assumes that the first items placed in inventory are sold first. This means the inventory at the end of a year consists of the goods most recently placed in inventory. FIFO is one method used to determine Cost of Goods Sold (COGS) for a business. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf, recorded on the income statement, because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be billed to ending inventory which appears on the balance sheet.
LIFO assumes that the last items placed in inventory are the first sold during an accounting year. This means the inventory at the end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the end. LIFO is one method used to determine Cost of Goods Sold for a business. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
Weighted Average is a method in calculation in which the weighted average cost per unit for the period is the cost of the goods available for sale divided by the number of units available for sale. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
Specific Identification is a method of tracking discovering ending inventory cost. Specific identification is usually used for large, easily traceable items, such as vehicles or furniture. It requires a very detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory. When this information is found, the amounts of goods are multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost. Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e.g., automobiles, fine jewelry, and so forth).
If prices were constant during the period, all three methods would produce the exact same result since each unit would have been purchased for an identical amount. But, since prices usually change, each method will produce different results. During periods of inflation, LIFO will generate a lower amount of gross profit and a lower inventory value. The FIFO method will produce a higher gross profit and a higher ending inventory balance. During periods of inflation, LIFO offers substantial tax savings due to lower profits and lower inventories. However, in periods of deflation, the effects are just the opposite.
FIFO assumes that the first items placed in inventory are sold first. This means the inventory at the end of a year consists of the goods most recently placed in inventory. FIFO is one method used to determine Cost of Goods Sold (COGS) for a business. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf, recorded on the income statement, because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be billed to ending inventory which appears on the balance sheet.
LIFO assumes that the last items placed in inventory are the first sold during an accounting year. This means the inventory at the end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the end. LIFO is one method used to determine Cost of Goods Sold for a business. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
Weighted Average is a method in calculation in which the weighted average cost per unit for the period is the cost of the goods available for sale divided by the number of units available for sale. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
Specific Identification is a method of tracking discovering ending inventory cost. Specific identification is usually used for large, easily traceable items, such as vehicles or furniture. It requires a very detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory. When this information is found, the amounts of goods are multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost. Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e.g., automobiles, fine jewelry, and so forth).
If prices were constant during the period, all three methods would produce the exact same result since each unit would have been purchased for an identical amount. But, since prices usually change, each method will produce different results. During periods of inflation, LIFO will generate a lower amount of gross profit and a lower inventory value. The FIFO method will produce a higher gross profit and a higher ending inventory balance. During periods of inflation, LIFO offers substantial tax savings due to lower profits and lower inventories. However, in periods of deflation, the effects are just the opposite.
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