Inventory costing methods
When identical goods are bought at different prices, businesses must choose which costs to assign to goods sold. The choice affects profit and taxes.
Why costing methods matter
If a store buys identical items at different prices during a period, it must decide which costs go to cost of goods sold and which stay in ending inventory. The methods are specific identification, FIFO, LIFO, and weighted average. The choice affects reported profit, inventory values, and taxes, but not the physical flow of goods.
Specific identification
Specific identification tracks the actual cost of each item sold. It is practical for unique, high-value items such as cars, jewellery, and art, but impractical for large volumes of identical goods.
FIFO
First-in, first-out (FIFO) assumes the oldest units are sold first, so COGS uses older costs and ending inventory uses the most recent costs. When prices are rising, FIFO gives lower COGS, higher profit, and an ending inventory value close to current cost.
LIFO
Last-in, first-out (LIFO) assumes the newest units are sold first, so COGS uses the most recent costs. When prices are rising, LIFO gives higher COGS, lower profit, and lower taxes. LIFO is allowed under US GAAP but not under IFRS; US companies using LIFO for tax must also use it in their financial statements (the LIFO conformity rule).
Weighted average
The weighted average method assigns each unit the average cost of all units available for sale: total cost of goods available / total units available. It smooths out price changes and gives results between FIFO and LIFO.
Lower of cost and net realisable value
If inventory's value falls below its cost, because of damage, obsolescence, or falling prices, it must be written down. Under IFRS and US GAAP for FIFO and average cost, inventory is reported at the lower of cost and net realisable value (estimated selling price minus costs to complete and sell). This reflects the principle of not overstating assets.
Inventory errors and ratios
An error in ending inventory affects COGS and net income in two periods: overstating ending inventory understates COGS and overstates income this period, then reverses next period. Inventory turnover (COGS / average inventory) measures how quickly inventory sells; days in inventory (365 / turnover) shows how long it sits.
Worked example
A shop starts with 10 units at 10 dollars, then buys 10 units at 12 dollars, and sells 15 units. FIFO COGS = 10 x 10 + 5 x 12 = 160; ending inventory = 5 x 12 = 60. LIFO COGS = 10 x 12 + 5 x 10 = 170; ending inventory = 50. Weighted average cost = 220 / 20 = 11; COGS = 165; ending inventory = 55. With rising prices, FIFO shows the highest profit.
Key takeaways
Costing methods assign costs to COGS and ending inventory without affecting physical flow. Specific identification suits unique items. FIFO uses older costs for COGS; in rising prices it gives higher profit. LIFO uses newer costs, lowering profit and taxes in rising prices, and is allowed under US GAAP but not IFRS. Weighted average smooths costs. Inventory is written down to the lower of cost and net realisable value. Inventory errors affect two periods; turnover measures how fast stock sells.
Flashcard
Tracks each item's actual cost
Check your understanding
When prices are rising, which method usually reports the highest net income?