Inventory Accounting: LIFO, FIFO and Weighted Average
In Accounting, there are three techniques used to manage inventory
. These techniques are; LIFO, which stands for "Last in First Out," FIFO, which stands for "First in First Out," and Weighted Average. The techniques mentioned are different in their processes and are used in different situations, but are all used to monitor and control inventory. Inventory is all the goods or items held available by a business. According to Investopedia (2010), inventory is one of the most important assets a business can have because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders/owners. So inventory is very important to the operation and efficiency of an organization.
Investopedia (2010) defines Last in First Out (LIFO) as an asset-management and valuation method that assumes that assets produced or acquired last are the ones that are used, sold or disposed of first. LIFO is generally used by organizations that have very large inventories and with inventory prices that are stable or slightly rising. It is also considered more accurate during times of inflation. The biggest benefit of using LIFO is that, in times of inflation, it reduces the taxable income and results paying fewer taxes, which in turn can lead to higher cash flow. LIFO is also more efficient in matching current costs with current revenues. However, there are certain disadvantages with using the LIFO technique. It mused be used on all financial reports, thus showing less profit than say using FIFO. This is good for tax breaks but could lower the condition of the company in the eyes future investors and banks. The keeping of old inventory can also result in aged, obsolete inventory. LIFO is also considered to be more complicated and therefore more prone to errors. Another possible disadvantage with using the LIFO system, a business is also liable to perform a LIFO liquidation. LIFO liquidation is when a company has to liquidate its older cheaper inventory. The older cheaper goods are matched with higher, current sales prices therefore inflating the profits and making the business liable to higher taxes.
Investopedia (2010) defines First in First Out (FIFO) as an asset-management and valuation method in which the assets produced or acquired first are sold, used or disposed of first. FIFO may be used by an individual or a corporation. First in First Out is generally used during stable or slightly falling inventory prices. FIFO is also considered much easier to use and is more logical and systematic. FIFO is generally used when inventories consist of large items with high per-unit costs, in which transaction numbers are not staggering. It uses up materials, which are acquired first by an organization rather than using what was received most recently. This allows an organization to clear out its older inventory, which prevents the aging of items and lowers the possibility of inventory decay and inventory liquidation. There are however several important disadvantages when using FIFO. When using this method, sales can be, but not always, associated with older, cheaper inventory. This can make the company look like is performing better than it really is, which may be considered by some as an important ethical issue. The older inventory they are getting rid of is limited and if inventory prices rise their profits will fall. Due to higher reported profits this method results in higher taxable income on inflated profits. FIFO can also become confusing if and when an organization makes multiple purchases but at different prices. If product costs are rising quickly the production cost is prone to being reported as understated.
According to Investopedia (2010), weighted average is an average in which each quantity to be averaged is assigned a weight. These weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that many like items with the same value involved in the average. All items in the inventory are priced the same, if the same item purchased at different times and different prices, these two are just averaged together to get the cost of goods sold. Those companies who have large inventories of undifferentiated product use the weighted average method. This method is generally in between LIFO and FIFO in regards of profit recording, FIFO reports the highest, LIFO the lowest and weighted average in the middle of the two. Weighted average usually refers to the cost flows of inventory, and usually not their physical flows.
www.investopedia.com., (2010). Last In, First Out FIFO. Retrieved from
http://www.investopedia.com/terms/l/lifo.asp
www.investopedia.com., (2010). First In, First Out FIFO. Retrieved from
http://www.investopedia.com/terms/f/fifo.asp
www.investopedia.com., (2010). Weighted Average. Retrieved from
http://www.investopedia.com/terms/w/weightedaverage.asp
Inventory Accounting: LIFO, FIFO and Weighted Average
By: Ben C.
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