FIFO, LIFO, and Weighted Average
FIFO, LIFO, and Weighted Average
Inventory is a very important aspect of business. There are many different ways for a company to manage its inventory, each method having advantages and disadvantages. Three very common methods are first in first out (FIFO), last in first out (LIFO), and Weighted Average. Theses three methods are used by many businesses around the world. Companies often chose the method of inventory they use based on factors such as current inflation, taxes, state of economy etc.
The first in, first out (FIFO) method is an inventory costing method that simply means the first item placed in inventory, will be the first item out when a sale is made. In other words inventory items are sold in the order they are acquired. When a sale is made a company will place the earliest cost of the items in their inventory on their cost of goods sold. When using the FIFO method the costs of the latest items placed in inventory are applied to the ending inventory. This method is very logical and systematic and is recommended when you are dealing with a great number of items. The FIFO method can be used even if the first item is not physically being sent out, the cost of the first unit is just applied to the cost of goods sold. This is also a great method if your dealing with products that may be damaged, or decay over time. FIFO also has some disadvantages particularly if many purchases are being made at different prices. It can also become a bit messy when there are many units from several different purchases in inventory at a given time.
An alternate option that is effectively the opposite of FIFO is the LIFO method. LIFO or last in first out is just as it sounds, the last items to be placed in inventory are the first items sold. The latest purchases are added to the cost of goods sold when a purchase is made, leaving the earlier purchases in ending inventory. Like FIFO, LIFO can be used even if the last good is not physically removed from inventory when an item is sold; the company just has to use the latest unit cost for the cost of goods sold. An advantage of LIFO is that since the most recent costs are being assigned to the cost of good sold it is the most accurate when you are comparing costs of goods sold with revenues. LIFO is a great method in industries that are subject to constant and large price fluctuation. LIFO is often applied in times of high inflation. If prices have skyrocketed due to inflation a company is using the FIFO method it would appear that the profits were much larger than they truly were, and this would cost the company additional money on their income taxes. LIFO gives a more accurate idea of profits even with inflation because items are being purchased for more and sold for more so there is no false appearance of a large profit.
Weighted Average is another inventory cost method that assumes the company takes an average price of all the units in the inventory at the time of the sale and applies that cost to the cost of goods sold. This method is also referred to as average cost. To get the average cost of each unit in inventory the prices of all units must be summed together and divided by the total number of units.
FIFO, LIFO, and Weighted Average
By: Scott Bradish
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