Your company has three inventory costing methods from which to choose. The choice is important because it influences your cost of goods sold, net income and income tax payable. Whichever method you choose, accounting rules call for you to stick with it; the Internal Revenue Service might not allow you to flip-flop your accounting method just to take advantage of the latest price trend. Show
About Costing MethodsLast-in, first-out, or LIFO, uses the most recent costs first. When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income. If you sell one-of-a-kind items like custom jewelry, you might prefer the specific identification method. You record the cost of each item, so the cost of goods sold doesn’t require as much fancy math. Periodic Inventory Under LIFOWhen you use the periodic, or book, inventory system, you value your inventory at specific intervals and lump together the results. For example, suppose you purchase 10 items at $100 each on the first of the month. On the 14th, you sell six items and on the 16th buy another 10 for $120 each. You sell eight items on the 19th and buy another 10 on the 23rd for $130 each. On the last day of the month, you sell nine items. Under periodic inventory LIFO, your cost of goods sold is the sum of 10 items times $130, 10 items times $120 and three items times $100. This adds up to $2,800, and you value your remaining inventory at $700. Perpetual Inventory Under LIFOIn the perpetual inventory system, you figure the cost at the time of each sale instead of at specific intervals. Your cost of goods sold on the 14th is six items times $100, or $600. The sale on the 19th costs $120 times eight units, or $960. The last sale costs $130 times nine items, or $1,170. Notice that each sale uses the latest item cost, which simplifies the math. The total cost is $2,730, or $70 less than the cost under the periodic inventory method. Your remaining inventory tallies in at $770. Your taxable income is $70 less using the periodic inventory system. If you are in the 25 percent bracket, this translates into a tax savings of $17.50. Things to ConsiderSince prices always seem to increase over time, LIFO is a good bet for consistently maximizing your cost of goods sold. The example deals with a retail situation but also applies to product manufacturers. However, if you manufacture products using raw materials that fluctuate in price, such as petroleum, you may not always benefit from the LIFO method. The IRS lets you initially choose your inventory accounting method but wants you to use it consistently year to year. If you choose LIFO, you must file IRS Form 970 in the first year you use this method. If you want to change methods, you might need to ask for IRS approval by filing Form 3115. Inventory accounting is a key aspect of your inventory management toolkit, because it allows you to evaluate your Cost of Goods Sold (COGS) and, ultimately, your profitability. What is inventory valuation?Inventory valuation is a calculation of the value of the products or materials contained in a company's inventory at the end of a particular accounting period. To help you pinpoint the right technique for your business, we’ve created a guide to the different inventory valuation methods along with examples. First-in-first-out (FIFO) inventory valuationAccording to the first-in-first-out (FIFO) inventory valuation method, it’s assumed that inventory items are sold in the order in which they’re manufactured or purchased. In other words, the oldest inventory items are sold first. The FIFO method is widely used because companies typically sell products in the order in which they’re purchased, so it best represents the actual flow of goods in a business. FIFO method example: Let’s say a business bought shirts on two separate occasions at two different prices during a month: 100 shirts at $10 200 shirts at $20 At the end of the month, the business had sold 50 shirts. With FIFO, we use the costing from our first transaction when we purchased 100 shirts at $10 each. So, after selling 50 shirts: COGS = (50 shirts x $10 FIFO cost) = $500 50 shirts from the first purchase are still left on the shelves, costed at $10 each, as well as the remaining 200 shirts from the second purchase at $20 each. So: Remaining inventory value = (50 shirts x $10 cost) + (200 shirts at $20 cost) = $4,500
Last-in-first-out (LIFO) inventory valuationThe last-in-first-out (LIFO) inventory valuation method assumes that the most recently purchased or manufactured items are sold first – so the exact opposite of the FIFO method. When the prices of goods increase, Cost of Goods Sold in the LIFO method is relatively higher and ending inventory balance is relatively lower. LIFO method example: Using the example above, the LIFO method would use the cost from the latest transaction when 200 shirts were purchased at $20 each. After selling 50 shirts: COGS = (50 shirts x $20 LIFO cost) = $1,000 The 100 shirts that we bought in the first purchase are still left at $10 each. We also have 150 shirts from the second purchase at $20 each. So: Remaining inventory value = (100 shirts at $10 cost) + (150 shirts at $20 cost) = $4,000 Weighted average cost (WAC) inventory valuationWith the WAC inventory valuation method, inventory and COGS are based on the average cost of all items purchased during a period. This method is usually used when a business doesn’t have much variation in its inventory. Weighted average cost example: Based on the example above, you have 300 (100+200) shirts, which you paid $5,000 for in total ($100 x 10 + $200 x $20). So, your weighted average cost would be the $5000 cost divided by the 300 shirts. This equals $16.67 per shirt. After selling 50 shirts: COGS = (50 shirts x $16.67 average cost) = $833.50 Remaining inventory value = (250 shirts remaining x 16.67 average cost) = $4,167.50
Generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS)It’s important to note that companies in the US operate under the generally accepted accounting principles (GAAP), while most other countries adhere to the International Financial Reporting Standards (IFRS). What’s the implication of this for inventory valuation? The GAAP accepts the three most common inventory valuation methods – FIFO, LIFO, and WAC – while the IFRS doesn’t accept the LIFO method. This means if your business is based anywhere other than the US, it’s likely you won’t be using the LIFO valuation method outlined above. There are also some differences between the way inventory is recorded according to the GAAP and IFRS. Under the GAAP, inventory is recorded as cost or market value – whichever is less. The IFRS, on the other hand, states that inventory should be recorded as cost or net realizable value – whichever is less. Which inventory valuation method is right for my business?Choosing the right inventory valuation method for your business depends on a number of factors, like where your business is based, whether your costs are going up or down, and how much your inventory varies. When it comes to inventory accounting methods, most businesses use the FIFO method because it usually gives the most accurate picture of costs and profitability. But there’s no one-size-fits-all solution – so it’s best to speak to an accounting professional to find out what’s best for your business and situation.
Which of the following inventory methods will always produce the same results under both a periodic and perpetual system?Periodic and perpetual FIFO will always produce the same cost of goods sold and ending inventory.
What is the FIFO inventory costing method?First In, First Out, commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first. For tax purposes, FIFO assumes that assets with the oldest costs are included in the income statement's cost of goods sold (COGS).
Which inventory cost flow methods produce the same cost of sales amount and ending inventory amount under periodic and perpetual inventory systems?With perpetual FIFO, the first (or oldest) costs are the first removed from the Inventory account and debited to the Cost of Goods Sold account. Therefore, the perpetual FIFO cost flows and the periodic FIFO cost flows will result in the same cost of goods sold and the same cost of the ending inventory.
Why is FIFO the best method?FIFO is an ideal valuation method for businesses that must impress investors – until the higher tax liability is considered. Because FIFO results in a lower recorded cost per unit, it also records a higher level of pretax earnings. And with higher profits, companies will likewise face higher taxes.
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