# Analyzing Inventory Costing Methods: FIFO, LIFO, and Average Cost

Categories: Math

## Introduction

Inventory management and costing are crucial aspects of a company's operational efficiency and financial reporting. Among the various methods, First-In, First-Out (FIFO) is widely recognized for its straightforward approach, assuming that the earliest products purchased are the first ones sold. This method aligns the cost flow with the physical flow of goods, making it intuitive for managing inventory costs.

## FIFO Method Calculation and Its Implications

### FIFO Ending Inventory and Cost of Goods Sold (COGS)

Using the FIFO method, we calculate the ending inventory and COGS with the following transactions:

• Beginning Inventory: 300 units @ \$7 each
• Purchases: Several acquisitions at varying costs, culminating in a sale of 1400 units.

Date Activity Units Cost/Unit Total Cost
Nov 7 Beginning 300 \$7 \$2,100
Nov 9 Purchase 450 \$8 \$3,600
Nov 17 Purchase 600 \$9 \$5,400
Nov 21 Purchase 750 \$10 \$7,500
Total Available 2100 \$18,600
• Ending Inventory Calculation: 700 units @ \$10 = \$7,000
• COGS: \$(2,100 + 3,600 + 5,400 + 7,500) - 7,000 = \$11,600

#### Advantage of the First In – First Out

The major advantage of FIFO it saves money and time in calculating the exact cost of the inventory being sold, because the cost will depend upon the most former cash flows of purchase to be used first.

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Some of the company’s managers have no concept of accounting information hence this method is easily to understand specially the mangers without hardship. Gradually FIFO is used globally because in time of inflation the cost ending remain similar to the trend cost.

#### Disadvantage of the First In – First Out

FIFO will not be suitable in period of inflation of price it will get clumsy, complex and difficult to manage the inventor price inflation also lead to many errors.

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Secondly the cost of goods sold base on the previous inventory prices which lead to be irrelevant to analysis the system after ending of the period, this require additional work period to adjust inflation and other factors that affect inventory value.

## Average Cost Method and Its Efficiency

The Average Cost method simplifies inventory price calculation, especially beneficial when handling large volumes of goods. This method averages the total cost of goods available for sale against the total units available for sale, providing a consistent unit cost for both ending inventory and COGS.

### Example of Average Cost Calculation

• Total Units: 2100, Total Cost: \$18,600
• Average Cost/Unit: \$18,600 / 2100 = \$8.857
• COGS: 1400 units * \$8.857 = \$12,399.8
• Ending Inventory Value: 700 units * \$8.857 = \$6,199.9

The advantage of average cost method it’s one of the technique use, it make calculation of the inventory price easier when the quantity volume of good is high. It’s less time consuming in setting price especially for estimating price for customer percentage makeup the calculation simpler on the cost of goods sold. Furthermore it illustrate more vivid and accurate picture of the business progress, in manipulation accounting figure method makes it complex.

In accounting, costing methods control how the company accounts for the expenses needed to produce products or services. This does not actually control the prices of the products or the costs necessary to make the products, but it does control how the expenses appear on company books. The simple average cost method combines various categories of product costs and then divides them out among the units produced to create an average cost marker. While easy to use, this method does have its downsides.

Some manufacturers try to circumvent the problems associated with the average method by creating a weighted average, which tips the scale more on some factors than others. In theory, this allows the business to focus on the most important costs and it can be a useful tool, but the company must still decide what factors to weight. If the business decides to weight the wrong costs, then the figures will not give an accurate representation of costs.

## Selection of Inventory Cost Flow Method: A Managerial Decision

Contrary to the belief that accountants solely determine the cost flow method, the selection is a strategic decision made by management to align with the company's goals and financial reporting agenda.

### Comparative Example: FIFO vs. Average Cost Method

Method Sales Revenue COGS Gross Profit
FIFO \$5,700 \$2,684 \$3,016
Average Cost \$5,700 \$2,877 \$2,823

The three technics method each has distinctive attraction, therefore the selection based on the interest of the corporation. For example the FIFO method it start with the old items the probability of profit is high as it’s in the illustration comparing to others method.

#### Fifo and Lifo Cost of Goods Sold

In periods of changing prices, the cost flow assumption can have significant impacts both on income and on evaluations of income, such as the following.

1. In a period of inflation, FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue.
2. In a period of inflation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.
3. If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest.
4. Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO.

To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income.Others believe that LIFO presents a more realistic net income number. That is, LIFO matches the more recent costs against current revenues to provide a better measure of net income. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that failing to match current costs against current revenues leads to an understatement of cost of goods sold and an overstatement of net income. As some indicate, net income computed using FIFO creates “paper or phantom profits”—that is, earnings that do not really exist

#### Balance Sheet Effects

The LIFO method results in the lowest taxable income, and thus the lowest income taxes, when prices are rising. For example the soccer company been using the FIFO it depict that COGS more than the average but in profit terms it has higher revenue than average method. The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use LIFO for financial reporting purposes. Companies may also report an alternative inventory amount in the notes to their financial statements for comparison purposes. Overall of high inflation period many companies switched from FIFO to LIFO for tax advantages.

### Conclusion

The choice between FIFO, LIFO, and the Average Cost method affects a company's financial statements significantly. While FIFO aligns with the physical flow of goods and may report higher profits during inflation, the Average Cost method offers simplicity and consistency in inventory valuation. Ultimately, the decision on which inventory costing method to use reflects a strategic choice by management, considering both the financial reporting implications and the operational realities of the business.

Updated: Feb 18, 2024