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FIFO method
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LIFO method
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Weighted average method
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Here’s what else to consider
Inventory costing is the method of assigning a value to the goods that are sold or stored by a business. It affects the profitability, cash flow, and tax liability of the business, so choosing the right method is crucial. In this article, we will explain the advantages and disadvantages of using three common inventory costing methods: FIFO, LIFO, and weighted average.
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- David Yurchi Instructional Technologist / Training Consultant at Railspeak 9
- Carmen E. Young II, CLT, DSL Logistician, Supply Chain Manager, Operations Specialist, Training Developer 4
- David Mastroianni Jr District Manager at United States Postal Service (Retired) 3
1 FIFO method
FIFO stands for first-in, first-out, which means that the oldest inventory items are sold or used first, and the newest ones are left in stock. This method reflects the actual flow of goods in most businesses, and it matches the current market prices of the inventory items. The advantages of using FIFO are that it reduces the risk of inventory obsolescence, it shows a higher net income and a lower cost of goods sold in periods of rising prices, and it is simple to apply and understand. The disadvantages of using FIFO are that it increases the tax liability in periods of rising prices, it shows a lower net income and a higher cost of goods sold in periods of falling prices, and it may not accurately reflect the actual cost of production or operations.
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- David Yurchi Instructional Technologist / Training Consultant at Railspeak
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Another drawback to FIFO is that it does not address the customers' desire to have the latest and greatest. This is a problem faced by car manufacturers at the end of the model year when they have unsold inventory in stock. Customers may not be interested in last year's model when they can have the shiny new one that has just arrived. Sometimes, dealers may have to resort to deep discounts to move the old inventory. The same can be said of cell phones. People want the latest model with all of its new features and fancy styling. They don't want people to think they are behind the times using an older version instead of the phones that are currently available. In this case, FIFO may be difficult to accomplish.
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2 LIFO method
LIFO stands for last-in, first-out, which means that the newest inventory items are sold or used first, and the oldest ones are left in stock. This method does not reflect the actual flow of goods in most businesses, but it matches the current cost of replacing the inventory items. The advantages of using LIFO are that it reduces the tax liability in periods of rising prices, it shows a higher net income and a lower cost of goods sold in periods of falling prices, and it reflects the current economic conditions more realistically. The disadvantages of using LIFO are that it increases the risk of inventory obsolescence, it shows a lower net income and a higher cost of goods sold in periods of rising prices, and it is complex to apply and understand, especially for international accounting standards.
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3 Weighted average method
Weighted average method is a compromise between FIFO and LIFO, which means that the inventory items are valued at the average cost of all the items in stock, regardless of when they were purchased or sold. This method smoothes out the fluctuations in prices and costs, and it reduces the distortion caused by extreme price changes. The advantages of using weighted average are that it shows a moderate net income and a moderate cost of goods sold in any period, it is simple to apply and understand, and it is acceptable for international accounting standards. The disadvantages of using weighted average are that it does not reflect the actual flow or replacement of goods, it may not capture the true profitability or efficiency of the business, and it may not be suitable for businesses that sell unique or perishable items.
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4 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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- Carmen E. Young II, CLT, DSL Logistician, Supply Chain Manager, Operations Specialist, Training Developer
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Excessive overhead expenses can be associated with the carrying costs of excessive production materials and finished goods in storage, especially products nearing obsolescence, the end of their respective life cycles, or shelf life.Depending on the nature of the goods, overproduction of stock can lead to excessive expenses due to storage and maintenance, which also affects costs associated with man-hours in maintenance and handling activities. Analysis of the demand, production, and fulfillment volume and velocity can mitigate cost overrun attributed to organizational operations. Results may be as far-reaching as the production/manufacturing philosophy.
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All the above drive very good points. Overhead, outdated, tax on inventories. If the production time of a product can be guaranteed for availability, JIT Just in Time would also be an option.
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