Weighted Average vs. FIFO vs. LIFO: An Overview
When it comes time for businesses to account for their inventory, businesses may use the following three primary accounting methodologies:
- Weighted average cost accounting
- First in, first out (FIFO) accounting
- Last in, first out (LIFO) accounting
Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Depending on the situation, each of these systems may be appropriate.
- When it comes time for businesses to account for their inventory, they typically use one of three different primary accounting methodologies: the weighted average method; the first in, first out (FIFO) method; or the last in, first out (LIFO) method.
- The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
- The first in, first out (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.
- The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold.
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 that 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.
First In, First Out (FIFO)
The first in, first out (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.
When a business uses 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.
Last In, First Out (LIFO)
The last in, first out (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.
Weighted Average vs. FIFO vs. LIFO: An Example
Consider this example: Suppose you own a furniture store, and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let’s assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations, are as follows:
- 200 chairs at $10 per chair = $2,000
- 300 chairs at $20 per chair = $6,000
- Total number of chairs = 500
Weighted Average Cost
- Cost of a chair: $8,000 ÷ 500 = $16/chair
- Cost of goods sold: $16 × 100 = $1,600
- Remaining inventory: $16 × 400 = $6,400
First In, First Out (FIFO) Cost
- Cost of goods sold: 100 chairs sold × $10 = $1,000
- Remaining inventory: (100 chairs × $10) + (300 chairs × $20) = $7,000
Last In, First Out (LIFO) Cost
- Cost of goods sold: 100 chairs sold × $20 = $2,000
- Remaining inventory: (200 chairs × $10) + (200 chairs × $20) = $6,000
Why would businesses use weighted average cost?
Businesses would use the weighted average cost method because it is the simplest of the three accounting methods.
Also, the weighted average cost method takes into consideration fluctuations in the cost of inventory. It does this by averaging the cost of inventory over the respective period. This helps businesses mitigate the impact of sharp price changes.
Finally, weighted average cost provides a clearer position of the costs of goods sold, as it takes into account all of the inventory units available for sale. This gives businesses a better representation of the costs of goods sold.
Why would businesses use first in, first out (FIFO)?
Businesses would use the FIFO method because it better reflects current market prices. This is achieved by valuing the outstanding inventory at the cost of the most recent purchases. The FIFO method can help ensure that the inventory is not overstated or understated.
Also, through matching lower cost inventory with revenue, the FIFO method can minimize a business’ tax liability when prices are declining.
Why would businesses use last in, first out (LIFO)?
Businesses would use the LIFO method to help them better match their current costs with their revenue. This is particularly useful in industries where there are frequent changes in the cost of inventory. This is achieved because the LIFO method assumes that the most recent inventory items are sold first.
Another reason why businesses would use LIFO is that during periods of inflation, the LIFO method matches higher cost inventory with revenue. This minimizes a business’ tax liability.
Finally, the LIFO method can act as a hedge against inflation. Given that the cost of inventory is premised on the most recent purchases, these costs are highly likely to reflect the higher inflationary prices.
The Bottom Line
There are three methods to determine the cost of goods sold and the value of inventory: weighted average cost accounting; first in, first out (FIFO) accounting; and last in, first out (LIFO) accounting.
Weighted average cost accounting calculates the average cost of all inventory units available for sale over a respective period, which is then used to determine the cost of goods sold and the value of ending inventory. This method tends to be the simplest to derive.
The FIFO method assumes that the oldest inventory units are sold first, while the LIFO method assumes that the most recent inventory units are sold first. FIFO tends to reflect current market prices better. LIFO better matches current costs with revenue and provides a hedge against inflation.
Choosing among weighted average cost, FIFO, or LIFO can have a significant impact on a business’ balance sheet and income statement. Businesses would select any method based on the nature of the business, the industry in which the business is operating, and market conditions. Decisions such as selecting an inventory accounting method can help businesses make key decisions in relation to pricing of products, purchasing of goods, and the nature of their production lines. Inventory costing remains a critical component in managing a business’ finances.