How to Calculate Inventory Valuation: FIFO, LIFO & Average

Identifying Costs for Inventory Valuation

Businesses must accurately identify all costs associated with acquiring or producing inventory before any valuation calculations can begin. These costs generally include the purchase price of goods from suppliers, freight-in costs for transport, and any other direct costs to bring inventory to its current condition.

For manufacturing businesses, inventory costs are more complex. They include direct materials (raw components), direct labor (wages for converting materials), and manufacturing overhead (indirect costs like factory rent, utilities, and equipment depreciation).

Accurately capturing these cost elements is essential for inventory valuation. Without a precise understanding of all expenditures, valuation methods like FIFO, LIFO, and weighted-average will produce inaccurate results, impacting financial statements.

First-In, First-Out (FIFO) Method

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. This aligns with the natural flow for many businesses, especially those with perishable goods. Under FIFO, ending inventory consists of the most recently acquired items, directly influencing the calculation of both cost of goods sold and ending inventory value.

For example, assume no beginning inventory. A business buys 100 units at $10.00 on January 10 and 150 units at $12.00 on January 20. If 200 units are sold on January 25, FIFO dictates the first 100 units sold are from January 10 ($1,000). The remaining 100 units sold come from January 20 ($1,200). Total Cost of Goods Sold (COGS) under FIFO is $2,200.

After selling 200 units, ending inventory consists of the remaining 50 units from the January 20 purchase, valued at $12.00 each ($600). FIFO generally results in a lower cost of goods sold and higher ending inventory values during periods of rising costs. This is because older, lower-cost inventory is expensed first, leaving newer, higher-cost inventory in stock.

Last-In, First-Out (LIFO) Method

The Last-In, First-Out (LIFO) method assumes the last goods purchased are the first ones sold. This means the most recently acquired inventory items are expensed first. Consequently, ending inventory consists of the earliest acquired items. This method can significantly impact a company’s financial performance, especially during fluctuating costs.

Using the same example (100 units at $10.00 on Jan 10, 150 units at $12.00 on Jan 20, 200 units sold on Jan 25), the LIFO calculation differs. Under LIFO, the 200 units sold first include all 150 units from January 20 ($1,800). The remaining 50 units come from January 10 ($500). Total Cost of Goods Sold (COGS) using LIFO is $2,300.

Ending inventory under LIFO comprises the oldest units. With 50 units remaining, these are assumed to be from the January 10 purchase, valued at $10.00 each ($500). While LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is not allowed under International Financial Reporting Standards (IFRS). This difference can lead to variations in reported financial results.

Weighted-Average Cost Method

The Weighted-Average Cost method determines the average cost of all goods available for sale. This approach assumes all units are indistinguishable, and the cost of each unit sold or remaining in inventory is the average cost of all available items. This method smooths out price fluctuations by not prioritizing any specific purchase order. The calculation involves dividing the total cost of all available units by the total number of units.

Using the previous example (100 units at $10.00 on Jan 10, 150 units at $12.00 on Jan 20), the total cost of goods available is ($10.00 100) + ($12.00 150) = $2,800. With 250 units available (100 + 150), the weighted-average cost per unit is $2,800 / 250 = $11.20.

When 200 units are sold on January 25, COGS is 200 units $11.20 = $2,240. Ending inventory is 50 units (250 available – 200 sold) $11.20 = $560. This method offers a middle-ground approach compared to FIFO and LIFO, reflecting a blend of costs.

How Method Choice Affects Financial Statements

The choice of inventory valuation method directly impacts a company’s financial statements, particularly the income statement and balance sheet. In periods of rising inventory costs, FIFO generally results in a lower Cost of Goods Sold (COGS) because older, less expensive units are sold first. This leads to higher gross profit and net income. FIFO also presents a higher ending inventory value on the balance sheet, as remaining inventory is valued at recent, higher purchase prices.

Conversely, during rising costs, LIFO typically yields a higher COGS because it assumes the most recently acquired, more expensive units are sold first. This results in lower gross profit and reduced net income. On the balance sheet, LIFO reports a lower ending inventory value, as remaining inventory is presumed to be older, less expensive units. The weighted-average method, by averaging costs, usually produces COGS and ending inventory values between FIFO and LIFO during consistent price trends.

In periods of falling inventory costs, these effects are generally reversed. FIFO would result in higher COGS and lower net income, while LIFO would lead to lower COGS and higher net income. The method chosen can also influence a company’s tax liability, as a higher COGS (e.g., under LIFO in rising cost environments) can lead to lower taxable income. Thus, the inventory method choice is a significant accounting decision influencing profitability and asset valuation.