Inventory Basics: FIFO, LIFO, and Weighted Average
For manufacturing firms, keeping track on the amount of inventory and the worth of the inventory is essential in equating the firms' assets
. Without knowing the worth or amount of units in their inventory, how is a business supposed to know when to make or purchase more goods? Also, a business needs to know these figures to be able to calculate the amount of units sold, the cost of the units sold, and the profit made on each unit. Of course, a company could walk through their warehouse and hand-count every single piece of inventory, but obviously that would be extremely tedious. For a company to accurately and quickly determine the worth of their inventory, they use basic accounting principles to estimate the amount of units they have and how much each is worth. To do this, they use FIFO, LIFO, or weighted average.
FIFO stands for First In-First Out. Using this system, firms assume that the first units they buy or manufacture will be the first units they sell. For example, let's say a firm purchased 10 units at a dollar a piece, and then purchased 10 units for two dollars a piece. After purchasing these 20 units, the firm sells 15 units. According to the FIFO accounting technique, they would calculate they sold the 10 units bought first (equating $10 for cost of goods sold) and then five units at two dollars a unit (an additional $10 for cost of goods sold). So for this method, the total cost of goods sold is $20. We will compare this cost of goods sold to the other two methods later on in the article. FIFO is used my most business, especially for firms that handle products that expire or are worthless past a certain point in time.
LIFO, which stands for Last In-First Out, is essentially the opposite of FIFO. Using this method, the units that are purchased or made most recently are the first units they sell. Let's use the example from above to show the difference between the different systems. Using LIFO, the firm would first calculate that they sold 10 units at two dollars a piece ($20 towards cost of goods sold) and an additional five units at a dollar a piece ($5 towards cost of goods sold). Using the LIFO method, the cost of goods sold is $25 in comparison to the $20 using FIFO. LIFO is used by companies to avoid have higher taxes during times of inflation. This method is rarely used.
Weighted average is more of a happy medium between the two methods. To calculate the cost of a unit, the firm calculates the total units in inventory and divides it by the total cost of all of the units to get an average cost per unit price. For the example above, the cost per unit would be $1.50 ($30/20 units). So, the firm would calculate that they sold 15 units at $1.50 a piece, equating in a total of $22.50 for cost of goods sold. This gives a firm a solid estimate, but isn't as accurate.
In summary, FIFO, LIFO, and weighted average are all acceptable ways to calculate inventory and cost of goods sold. Depending on the way that firms sell their products, a firm should pick the method that works best for them. Also, hopefully you aren't mislead into thinking that FIFO always results in the lowest amount of cost of goods sold. If the more expensive units were bought first in the example, then LIFO would have the lower cost of goods sold. The example just proved that a firm will get different results based on the method they used.
Inventory Basics: FIFO, LIFO, and Weighted Average
By: Alex
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