Where inventory consists of small number of large or precious items, it is possible to identify individual items of inventory and their actual costs. However, in most of the cases, it is not possible. Usually inventory consists of large number of items and keeping track of actual costs of each item is virtually impossible. To address this matter, accountants use inventory valuation methods involving certain cost flow assumptions. In this chapter, we’ll briefly discuss various inventory valuation methods used in the accounting of inventory.
When inventory is sold, questions arise like what should be the cost of inventory that has been sold? What amount should be taken to the income statement as cost of goods sold? For example, a retailer purchased identical dry fruits packages at $90, $95, and $100 on the first, second and third day of December 20X1, respectively. On 7th December 20X1, a customer purchased one dry fruit package. What cost should be transferred to the income statement? Whether it should be $90, $95, $100, or average cost?
One of the following inventory valuation methods can be used to answer such questions:
- First-in, First-out method (FIFO)
- Weighted average cost method (AVCO)
- Last-in, First-out method (LIFO)
It must be noted that these inventory valuation methods use certain cost flow assumptions. Actual flow of inventory may differ from what is assumed by the valuation method adopted. In the above example, let’s assume that the dry fruit package sold to the customer is the one that was purchased for $100, and the retailer follows FIFO method. In accounting records, $90 will be transferred from inventory account to cost of goods sold as per first-in, first-out cost flow assumption.
Let’s briefly discuss all three inventory valuation methods.
First-in, First-out method (FIFO)
In FIFO, it is assumed that inventory items are sold or consumed in the order in which these items are purchased or manufactured. Older items of inventory get sold first and newer items remain in the inventory. However, it must be noted that this is merely an assumption used to calculate the cost of goods sold and value of inventory in hand. Actual physical flow of inventory may not be in accordance with this FIFO assumption.
Weighted average cost method (AVCO)
Cost of goods sold and value of inventory in hand under AVCO method is calculated using the following formula:
W. avg cost per unit = Total cost of inventory / No. of units in inventory
Last-in, First-out method (LIFO)
In LIFO, it is assumed that newer items of inventory are sold first, and older items remain in the inventory. However, it must be noted that this is merely an assumption used to calculate the cost of goods sold and value of inventory in hand. Actual physical flow of inventory may not be in accordance with this LIFO assumption.
Application of LIFO is not allowed in financial accounting as per International Accounting Standard – 2 (IAS-2). However, some other financial reporting standards such as US GAAP allow the application of LIFO method of inventory valuation.