At the end of every monthly and yearly period, it’s important for store owners to conduct a thorough physical inventory count to determine the number of inventory items presently on hand. And when it comes to accounting for inventory, businesses may use the following three chief methodologies:
Each of these disciplines relies on a different method of calculating both the inventory and cost of goods sold, and each system is appropriate for different situations.
The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.
To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted-average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.
While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories.
The FIFO accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. In other words, under FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.
The LIFO accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.
Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily: LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.
Still confused by all of the above? Consider this example. Say you’re a furniture store and you purchase 200 chairs for $10/unit. The next month, you buy another 300 chairs for $20 each. At the end of an accounting period, assume you sold 100 total chairs. The weighted average costs, using both FIFO, and LIFO considerations, are as follows:
Example: 200 chairs @ $10 = $2,000. 300 chairs @ $20 = $6,000. Total number of chairs = 500
Weighted Average Cost: Cost of a chair: $8,000 divided by 500 = $16/chair. Cost of Goods Sold: $16 x 100 = $1,600. Remaining Inventory: $16 x 400 = $6,400
FIFO: Cost of goods sold: 100 chairs sold x $10 = $1,000. Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000
LIFO: Cost of goods sold: 100 chairs sold x $20 = $2,000. Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000.
This question was answered by Chizoba Morah.