Inventory Accounting Methods
Companies such as resellers or manufacturers often needs to keep products or raw materials in stock. This stock of items is called as inventory. Inventories makes up the most valuable current asset for such companies so it is important to determine and keep track of their costs. Inventory accounting is the process to do that. There are various methods for inventory accounting. Generally accepted accounting principles (GAAP) has defined such accounting methods. Four most common GAAP accounting methods are - Specific Identification Method, Weighted Average Method, FIFO Method, and LIFO Method. Choosing an appropriate method is very important because it can impact earnings and current assets of a company. A particular method can be well suited for some business types than others. Companies can choose any of these methods irrespective of how actually their inventories are sold. They must adhere to guidelines from IRS in this matter.
Specific Identification Method:
In this method, companies records cost to acquire goods as well as cost of goods sold for each inventory item individually. This method is most suitable for companies which have limited inventory, cost per unit of inventory items are high and items are relatively unique. Jewelers, car dealers, art galleries etc. are the examples of businesses where this method is suitable. It is the most precise way of determining inventory prices but is too cumbersome for companies with large or medium-sized inventories.
Weighted Average Method:
In Weighted Average Method companies determines the weighted average cost of the inventory. This method is suitable for companies that maintain a large inventory of uniform items such as fuels or grains.
FIFO Method:
FIFO stands for First In First Out. In FIFO method it is assumed that the oldest inventory or the inventory which was purchased first is sold first. Inventory from recent purchases are sold later. This method is suitable for companies selling perishable goods such as food or drugs.
LIFO Method:
LIFO stands for Last In First Out. In LIFO it is assumed that the most recent purchased inventory is sold first. Prior or old inventory is sold later. A company in coal business is a good example where LIFO method is obvious. Coal on top of the coal pile is always going to be sold first.
Comparison of above methods:
Let's understand the difference between above four methods through example. Assume that a company purchases four identical items at different times during an accounting period (For Specific Identification method assume items are unique).
Assume that a company now sells one item of this inventory at $25. The cost of goods sold, profit and ending inventory balance will differ depending on the choice of an accounting method.
If the 2nd item is sold using Specific Identification method then the cost of goods sold would be $18, profit would be $7, and ending inventory balance would be $57 ($15+$20+$22).
Using FIFO method, the cost of goods sold would be $15, profit would be $10, and ending inventory balance would be $60 ($18+$20+$22).
Using LIFO method, the cost of goods sold would be $22, profit would be $3, and ending inventory balance would be $53 ($15+$18+$20).
Using Weighted Average method, the cost of goods sold would be $18.75 (($15+$18+$20+$22) / 4), profit would be $6.25, and ending inventory balance would be $56.25 ($18.75 x 3 remaining items).
Specific Identification method's numbers are not comparable against numbers from other methods because of uniqueness of its items in inventory. It is evident from the numbers of remaining three methods that FIFO has the lowest cost of goods sold, the highest profit, and the highest ending inventory balance. Companies following FIFO method pays higher taxes because of higher profits. LIFO is just opposite and offers substantial tax savings due to lower profits and lower inventories. It is important to note that in the example cost of item was inflated at each purchase. If the cost of purchase is reversed in order i. e. deflated then the effects of FIFO and LIFO will be just opposite. The Weighted Average method falls in between FIFO and LIFO methods.
Since choice of inventory accounting method has significant effect on company's income statement and balance sheet, it is very important to consult knowledgeable resources such as an accountant or CPA.
Specific Identification Method:
In this method, companies records cost to acquire goods as well as cost of goods sold for each inventory item individually. This method is most suitable for companies which have limited inventory, cost per unit of inventory items are high and items are relatively unique. Jewelers, car dealers, art galleries etc. are the examples of businesses where this method is suitable. It is the most precise way of determining inventory prices but is too cumbersome for companies with large or medium-sized inventories.
Weighted Average Method:
In Weighted Average Method companies determines the weighted average cost of the inventory. This method is suitable for companies that maintain a large inventory of uniform items such as fuels or grains.
FIFO Method:
FIFO stands for First In First Out. In FIFO method it is assumed that the oldest inventory or the inventory which was purchased first is sold first. Inventory from recent purchases are sold later. This method is suitable for companies selling perishable goods such as food or drugs.
LIFO Method:
LIFO stands for Last In First Out. In LIFO it is assumed that the most recent purchased inventory is sold first. Prior or old inventory is sold later. A company in coal business is a good example where LIFO method is obvious. Coal on top of the coal pile is always going to be sold first.
Comparison of above methods:
Let's understand the difference between above four methods through example. Assume that a company purchases four identical items at different times during an accounting period (For Specific Identification method assume items are unique).
- 1st item is purchased at a cost of $15
- 2nd item is purchased at a cost of $18
- 3rd item is purchased at a cost of $20
- 4th item is purchased at a cost of $22
Assume that a company now sells one item of this inventory at $25. The cost of goods sold, profit and ending inventory balance will differ depending on the choice of an accounting method.
If the 2nd item is sold using Specific Identification method then the cost of goods sold would be $18, profit would be $7, and ending inventory balance would be $57 ($15+$20+$22).
Using FIFO method, the cost of goods sold would be $15, profit would be $10, and ending inventory balance would be $60 ($18+$20+$22).
Using LIFO method, the cost of goods sold would be $22, profit would be $3, and ending inventory balance would be $53 ($15+$18+$20).
Using Weighted Average method, the cost of goods sold would be $18.75 (($15+$18+$20+$22) / 4), profit would be $6.25, and ending inventory balance would be $56.25 ($18.75 x 3 remaining items).
Specific Identification method's numbers are not comparable against numbers from other methods because of uniqueness of its items in inventory. It is evident from the numbers of remaining three methods that FIFO has the lowest cost of goods sold, the highest profit, and the highest ending inventory balance. Companies following FIFO method pays higher taxes because of higher profits. LIFO is just opposite and offers substantial tax savings due to lower profits and lower inventories. It is important to note that in the example cost of item was inflated at each purchase. If the cost of purchase is reversed in order i. e. deflated then the effects of FIFO and LIFO will be just opposite. The Weighted Average method falls in between FIFO and LIFO methods.
Since choice of inventory accounting method has significant effect on company's income statement and balance sheet, it is very important to consult knowledgeable resources such as an accountant or CPA.
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