FORDHAM BUSINESS DEVELOPMENT COLLABORATORY
Inventory Accounting Methods:
LIFO, FIFO, & Weighted Average
Cost
Prepared by: John Raymond, Nandhana Nair, Danny Ye
Date: 1/18/2021
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Introduction
Inventory valuation is an important accounting measure to keep track of the monetary asset value
of inventory not yet sold at the end of a business’ accounting period. Typically, inventory will be
the largest business asset on a balance sheet (such as that of a retail or manufacturing business).
By evaluating your company’s cost of goods sold (COGS) and inventory carrying costs, you can
better optimize cost-reductions, purchase schedules, and subsequently, profitability. Inventory
value will affect COGS as the stock inventory at the beginning of the period is subtracted by the
stock inventory at the end of the period with consideration to purchases (COGS = Beginning
Inventory + Purchases - Ending Inventory). If the ending inventory is overvalued, it will in turn
inflate the profit of the period and reduce profits of future periods.
The most common methodologies are FIFO, LIFO, and WAC; specific identification is
another method that is less commonly utilized. Under GAAP (Generally Accepted Accounting
Principles) set by the FASB (Financial Accounting Standards Board), public companies have the
flexibility to choose which of the first three methods mentioned above they will file their company
reports with. In comparison, international companies under IFRS (International Financial Reporting
Standards), issued by the IASB (International Accounting Standards Board), are required to use
FIFO only. There has been controversy over the use of LIFO as the Obama administration
attempted to challenge the legality of LIFO back in 2014 with the argument that it enabled
companies to deflate their incomes as a means to reduce their tax contributions; opponents to
LIFO-repeal fear that economic growth would slow as cost of capital would increase.
Inventory management is a highly important process in running a business as it ties into
sourcing, storing, and selling. Optimizing businesses to hold the right quantities of stock, in the
right place, and at the right time will result in positive impacts on company revenue and expenses.
Clear visibility of inventory value will help to enhance customer service and fulfillment, reduce
carrying costs, and prevent return losses and product expiration. Most SMBs (small-to-medium
sized businesses) will use Google Sheets, Excel, and Microsoft Access to manage their inventory
and ordering databases, but other apps such as Cin7, NetSuite, and inFlow also offer proprietary
management software which may be more effective in specific business types.
The FIFO Method
The FIFO (or First-in, First-Out) Method is based on the concept that the first inventory purchased is the
first to be sold. It is assumed that the remaining inventory is matched to the assets that were most recently
purchased or produced. In other words, assigned costs are based on the order in which the product was
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used, which helps companies to avoid the obsolescence of their products. This is both the simplest and
most common method of inventory valuation. During times of inflation, FIFO will yield a higher value of
inventory, lower COGS, and consequently, greater gross profit. Since the newest inventory was purchased
at a higher, inflated price, the ending inventory balance would be inflated.
❖ FIFO = First-In, First-Out
❖ Assumes first items bought are the first items to be sold.
❖ In an inflationary market, older/lower costs are assigned to COGS which will result in higher net
income for the period.
The LIFO Method
The LIFO (or Last-in, First-out) Method is based on the assumption that the inventory acquired most
recently by the firm is the first inventory to be sold to customers. The tendency of goods to be acquired by
firms at increasing prices over time means that the latest goods are the most expensive, and reporting their
sale instead of the cheaper goods means reporting a lower net profit, and consequently paying fewer
taxes. This relationship scales with the extent to which prices for goods increase every year, so it tends to
be the method of choice for grocery stores, car dealerships, and convenience stores; all of these industries
experience large increases in the price of acquiring goods throughout the year.
One problem associated with switching to LIFO is that unless a firm sells completely out of inventory,
goods acquired first may remain on the balance sheet indefinitely. Additionally, lower reported income may
look worse for potential investors, since it equates to lower earnings per share. In many cases, LIFO may
also undervalue current inventory. These are all reasons why many business owners opt for the FIFO
method of accounting. However, for many businesses, the benefits can still outweigh these drawbacks.
❖ LIFO = Last In, First Out
❖ Assumes latest items bought are first to be sold.
❖ Tax advantageous in an inflationary market.
❖ LIFO Reserve = the difference between COGS using LIFO vs. FIFO
The Weighted Average Cost Method
The Weighted Average Cost (WAC) method is another way of valuing ending inventory and COGS. It is
mostly used when it is difficult to assign a specific cost to a unit of inventory because the inventory items
are intertwined. To calculate WAC per unit, divide the total cost of goods available for sale by the number
of units available for sale. This assigns a standard average cost to each unit of inventory. While this method
is accepted under GAAP, it is not as sophisticated as FIFO or LIFO. Some benefits of WAC include that it is
one of the simplest ways to track inventory and is consistent across all stock units. However, this method
lacks in situations where inventory prices vary, as it assumes that all units of inventory are identical, when
in reality some may be more or less expensive.
❖ WAC= Weighted Average Cost
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❖ Takes the weighted average cost of all units available for sale to determine inventory and COGS
❖ Always produces results that fall between those from FIFO and LIFO
The Specific Identification Method
The Specific Identification Method is used when a company can individually track each item in its
inventory. This method is the most common for smaller businesses as it is easier to track inventory count
and specific units. Under this method, the cost of each purchased item is determined and recorded so that
the COGS and value of ending inventory are able to be calculated exactly. However, while this method is
incredibly accurate, it can be complicated for larger companies to track precisely the cost of each item and
the amount received from the sale.
❖ Track every item sold and purchased specifically
❖ Highly accurate, but time-consuming
❖ Requires tracking of every item of inventory, which can be complicated
Applied Example
MONTH
AMOUNT
PRICE PAID PER
UNIT
TOTAL COST
January
10 Units
$100
$1,000
February
10 Units
$100
$1,000
March
10 Units
$125
$1,250
April
10 Units
$125
$1,250
May
10 Units
$125
$1,250
June
10 Units
$150
$1,500
July
10 Units
$150
$1,500
August
15 Units
$175
$2,625
September
15 Units
$175
$2,625
October
15 Units
$200
$3,000
November
15 Units
$200
$3,000
December
15 Units
$200
$3,000
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Total
145 Units
$23,000
Assume a total of 110 units were sold for the year.
FIFO Method
Cost calculations start at the top (earliest bought
inventory) and expend the costs as units are
consumed moving downwards.
20 units x $100
= $2,000
30 units x $125
= $3,750
20 units x $150
= $3,000
30 units x $175
= $5,250
10 units x $200
= $2,000
TOTAL COGS
= $16,000
To calculate ending inventory from COGS:
COGS = Beginning Inventory + Purchases - Ending
Inventory
Beginning Inventory + Purchases = $23,000 (from
original table)
$16,000 = $23,000 - Ending Inventory → Ending
Inventory = $7,000
LIFO Method
Cost calculation assumes that the latest bought
inventory at the bottom is sold first. Since the last
110 units average a higher price than the first, total
COGS is higher.
45 Units x $200
= $9,000
30 Units x $175
= $5,250
20 Units x $150
= $3,000
15 Units x $125
= $1,875
TOTAL COGS
= $19,125
To calculate ending inventory from COGS:
COGS = Beginning Inventory + Purchases - Ending
Inventory
Beginning Inventory + Purchases = $23,000 (from
original table)
$19,125 = $23,000 - Ending Inventory → Ending
Inventory = $3,875
WAC Method
Divide the total cost of goods available for sale by the total number of units available (values taken from
the original table)
Total number of units available = 145 Units
Total cost of goods available for sale = $23,000
Weighted Average Cost of Each Unit = $23,000 / 145 units = $158.62
COGS = Number of Goods Sold x Weighted Average Cost = 110 Units sold x $158.62 = $17,448.28
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To calculate ending inventory from COGS:
COGS = Beginning Inventory + Purchases - Ending Inventory
Beginning Inventory + Purchases = $23,000 (from original table)
$17,448.28 = $23,000 - Ending Inventory → Ending Inventory = $5,551.72
Conclusion
Here, please conclude your report. This should sum up everything you have discussed.
Works Cited
https://www.tradegecko.com/inventory-management#:~:text=Inventory%20management%20is%20a%20
systematic,cost%20as%20well%20as%20price.
https://www.investopedia.com/articles/investing/052815/when-why-should-company-use-lifo.asp#:~:text=
When%20prices%20are%20rising%2C%20it,as%20retailers%20or%20automobile%20dealerships.
https://www.unleashedsoftware.com/blog/weighted-average-cost-method-inventory-valuation
https://www.investopedia.com/ask/answers/09/weighted-average-fifo-lilo-accounting.asp#:~:text=To%20u
se%20the%20weighted%20average,the%20cost%20of%20goods%20sold.
https://corporatefinanceinstitute.com/resources/knowledge/accounting/weighted-average-cost-method/
https://www.investopedia.com/articles/02/060502.asp
https://corporatefinanceinstitute.com/resources/knowledge/accounting/specific-identification-method/
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