The accounting method that a company decides to use to determine its inventory costs can directly impact the balance sheet, income statement and statement of cash flow
Choosing the correct inventory valuation method is a crucial step for a business and can have a significant impact on reported profitability, so here we’ll look at the strengths and weaknesses for each approach. Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.
The accounting method that a company decides to use to determine its inventory costs can directly impact the balance sheet, income statement and statement of cash flow.
There are three general classes of costs that are important to determine inventory policy:-
Associated with acquisition of goods for the replenishment of inventories
Results from storing or holding goods for a period. This may be space costs, capital costs, inventory service costs, and/or inventory risk costs
Incurred when an order is placed but cannot be filled from the inventory to which the order is normally assigned
- The first item purchased/produced is the first item sold
- The Cost of Goods (COGS) consists of the first items sold
- Ending inventory consists of most recent purchases, which is a better approximation of the current cost
- Under FIFO method, the ending inventory is based on most recent purchases which is a better approximation of the current cost. Should the inventory purchased be subject to high levels of inflation, FIFO accounting will understate the cost of goods compared to the current base. Earnings may therefore be over stated and overestimate a company’s ‘real’ income.
- The last item purchased/produced is the first item sold
- The Cost of Goods (COGS) consists of the last items sold
- Ending inventory consists earliest purchases costs
- Under LIFO method, as the item purchased most recently is assumed to be the first item sold, in an inflationary environment the cost of goods sold will be higher than under the FIFO method and earnings will be lower. Lower earnings enable the company to pay less taxes and increases the company’s net cash flow. Since ending inventory is valued using the earliest costs, in an inflationary environment LIFO ending inventory is less than the actual current cost.
- It takes the weighted average of all units available for sale during the accounting period
- Uses that average cost to determine the value of Cost of Goods Sold (COGS)
- The ending inventory consists of Average cost
- Average cost method is sometimes also called as moving average price. Moving average price recalculates the material price after each transaction, meaning that the price used is dependent on the timing of the transaction in the system. For example, if an invoice receipt or settlement is posted after a goods issue then the posting will not be reflected in the material of the material issued.
An important point is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets. If inflation were non-existent, then all 3 of the inventory valuation methods would produce the exact same results. When prices are stable, we would be able to produce all our inventory at same cost and FIFO, LIFO and average cost would be equal. Unfortunately, Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.
If prices are rising, each of the accounting methods would produce the following results:
(Note: if prices are decreasing, then the opposite of the above is true.)
Many companies will also state that they use “lower of cost or market.” This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO or average cost.
When firms purchase and sell inventory, the cost of their products sold must be reported in the income statement under ‘Cost of goods sold’. If the cost of a firm’s inventory were to remain constant over time, determining the firm’s cost of goods sold would be easy! However, since the cost of inventory changes over time a firm must select a cost flow formula to allocate inventory costs. Firms do have the flexibility to select more than one inventory method, however they must select an inventory method for items of similar nature and usage.