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Inventory Costing Methods - FIFO,LIFO and Average Cost

Explain the basis accounting unventories and describe the inventory cost flow methods

Tina S
Tina S
Dec 15, 2009
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LIFO, which stands for "last in, first out," and FIFO, which stands for "first in, first out," are terms commonly used in inventory control, in cost accounting and in computer science. They all stand for literally the same phrases, but it means something different in each application.

In accounting, LIFO and FIFO mean two different ways of setting a value on your existing inventory and calculating your profit. Some retailers stock an individual type of item only once and then when it has sold out, they no longer carry it; ephemeral fads and fashions are examples of stock-once items. So they pay the same price for each unit of that particular item, and have no decision to make when valuing their inventory. Most retailers, however, stock a particular item for some time, replenishing their supply as they run low. The price on the item fluctuates with time, usually going up, alas. So the newest items you purchase may cost more (or less) than the ones you have had for awhile.

Because specific identification is often impractical, other cost flow methods are allowed. These assume flows of cost that may be unrelated to the physical flow of goods.
For this reason we call them assumed cost flow methods or cost flow assumptions. They are:

1.    First-in, first-out (FIFO)
2.    Last-in, first-out (LIFO)
3.    Average cost

FIFO accounting

FIFO accounting is a common method for recording the value of inventory. It is appropriate where there are many different batches of similar products.
The method presumes that the earliest goods purchased are the first to be sold in warehouse. Under FIFO method, the costs of the earliest goods purchased are the first to be recognized as cost of goods sold.
In practice, this usually reflects the underlying commercial substance of the transaction, since many companies rotate their inventory. This is in contrast to LIFO.

Calculating FIFO
1. Record the same price and unit list of the products currently in the company's inventory, and rank the information according to date so that the most recent inventory purchases will be at the top of the list.

2. Determine the number of units sold from inventory. Multiply the prices the company paid for the oldest units by the number of units sold to determine the FIFO cost of goods sold.

3. 
The allocation of goods for sale:
 
         Pool of Cost
Cost of Goods Available for Sale
Date Explanation Units Unit Cost Total Cost
1/1 Beginning inventory 100 10 1000
3/13 Purchase 200 12 2400
4/23 Purchase 300 11 3300
7/21 Purchase 400 12 4800
  Total 1000 45 11500

The computation for the 500 units sold are showen follows:
 
Date Units Unit Cost Total Cost
1/1 100 10 1000
3/13 200 12 2400
4/23 200 11 2200
Total     5600

Application
Perishable items such as milk and eggs are restocked from the back, so that the old items are pushed to the front and are the first selected by shoppers; this is a FIFO restocking method. This is why most convenience stores have walk-in coolers behind their cold displays, so that they can stock from the rear.

Effects
In an economy of rising prices (during inflation), it is common for beginning companies to use FIFO for reporting the value of merchandise to bolster their balance sheet. As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company's books. Having the higher valued assets and the lower purchase costs of the sold goods part of the company's books, increases the chances of getting a loan from potential creditors for the company. However, as the company grows it may switch to LIFO to reduce the amount of taxes it pays to the government.

LIFO accounting

Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year.
Under the LIFO method, the cost of the latest goods purchased are the first to be assigned to cost of goods sold.

Calculating LIFO

 The allocation of goods for sale:
 
 
Date Explanation Units Unit Cost Total Cost
1/1 Beginning inventory 100 10 1000
3/13 Purchase 200 12 2400
4/23 Purchase 300 11 3300
7/21 Purchase 400 12 4800
  Total 1000 45 11500
 
The computation for the 500 units sold are shown follows:
 

Date Units Unit Cost Total Cost
7/21 400 12 4800
4/23 100 11 1100
Total     5900
 
Application

This would be a typical stocking method for items that have no 'sell-by' date associated with them, or at least one that is in the distant future, such as canned good.

Effects

Since prices generally rise over time, this method records the sale of the most expensive inventory first and thereby can reduce taxes. However, this method rarely reflects the physical flow of indistinguishable items (perhaps a heap of coal with shipments being added to and taken from the top might be an isolated case) and is not permitted under UK GAAP and IAS.

However, LIFO valuation is permitted under US GAAP in the belief that an ongoing business does not realize an economic profit solely from inflation. Canadian GAAP permits its use for reporting purposes, while the Canada Revenue Agency does not allow LIFO to be used for tax filing. When prices are increasing, they must replace inventory currently being sold with higher priced goods. LIFO better matches current cost against current revenue. It also defers paying taxes on phantom income arising solely from inflation. LIFO is attractive to business in that it delays a major detrimental effect of inflation, namely higher taxes.

Average Costing Method

The average cost material assumes that the goods available for sale have the same (average) cost per unit. Generally such goods are identical. Under this method, the cost of goods available for sale is allocated on the basis of the weighted average unit cost.

The basics of the average-cost method are that it simply gives the average of the total cost of all items that are and were in inventory. This is the simplest of all three methods to keep track of for someone who is not familiar with accounting.

Calculation
The allocation of goods for sale:
 
 
Date Explanation Units Unit Cost Total Cost
1/1 Beginning inventory 100 10 1000
3/13 Purchase 200 12 2400
4/23 Purchase 300 11 3300
7/21 Purchase 400 12 4800
  Total 1000 45 11500
 
The computation for the 500 units goods:

units 
cost      units
 
11500/1000 = 115

Application

Many retail sites use an average cost method inventory system in order to better adjust to changes in the wholesale price of items; the average cost method of inventory control allows companies to maintain a more accurate basis for pricing goods for sale.

For investors, the average cost method accounting system is used to calculate the cost basis for securities bought or sold during a certain year for tax purposes. The value for purchased stocks is derived by taking the total cost of purchasing shares and dividing them by the total number of shares; this derives an average figure for each share, which is used to determine the cost basis. This figure is then offset against the gain or loss derived when the stocks are sold.




 
 
Keywords: Inventory Costing Methods,fifo,lifo,average cost,weighted average cost,application,tax,average method for securities,GAAP,inflation,effects.



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