FIFO vs. LIFO vs. the Average Cost Method

What Is the Average Cost Method?

The average cost method is a method of inventory costing that calculates the average cost of all items in your inventory. To use the average cost inventory method, record the cost of each item purchased, add them together, and divide them by the total number of items in inventory. The resulting value is the average cost per unit. Then, you use this value to determine the cost of goods sold, ending inventory, and gross profit.

When Is the Average Cost Method Most Appropriate?

If your company manufactures large numbers of similar products, the average cost inventory method might be an excellent choice to calculate your inventory value. It’s also easier to track since you don’t need to track each item and its cost.

Similarly, if you handle raw materials, prices often fluctuate. When you use this method, it can help company management better conduct long-term planning and budgeting.

What Is the FIFO (First In, First Out) Method?

FIFO stands for first in, first out and is a method of inventory costing that assumes the oldest items are sold first. Using this method, you would calculate the cost of goods sold using the cost of the oldest items in inventory. Then, you would calculate the ending inventory using the cost of the newest items.

When Is the FIFO Method Most Appropriate?

Since most companies sell their older products before their newer ones, this method mirrors the flow of inventory as it moves from production to sales. If you’re operating in inflationary times, FIFO can make your business appear more profitable to investors and lenders.

It’s also a method that works well with industries that sell perishable products. In such industries, older inventory often ends up in the trash.

As the price you pay for materials rises, you’ll sell off your older inventory first. Since the price you’ve paid to produce those goods is less than your newer products, your ledger will show more revenue.

However, there is a downside to the FIFO method. Having a higher income on the ledger could trigger higher tax rates.

What Is the LIFO (Last In, First Out) Method?

LIFO stands for last in, first out and is a method of inventory costing that assumes that you sold the newest items first. Therefore, you’ll calculate the cost of goods sold using the cost of the newest items. Then, you’ll calculate the ending inventory with the cost of the oldest items in your inventory.

When Is the LIFO Method Most Appropriate?

Using LIFO can reduce profits and, hence, taxes. That advantage is especially apparent when your products have a long shelf life since you calculate the COGS based on the newest products in your inventory.

However, if you need investors or a line of credit, that factor can work against you.

There are a few other catches to using the LIFO method. Once you choose that method, you must apply to the IRS for permission if you want to switch to FIFO.

The Differences Between the Average Cost Method, FIFO, and LIFO

The main difference among the options — the average cost method, FIFO, and LIFO — is how each calculates the cost of goods sold and ending inventory.

While the average cost inventory method takes an average of all inventory items, FIFO and LIFO both use specific identification. That means they take the actual cost of specific items sold or those remaining in your inventory.

Therefore, price fluctuations can affect the cost of goods sold and ending inventory differently, depending on which method you use.

Another difference between these inventory valuation methods is their effect on net income and tax liability. FIFO tends to result in higher net income and taxes, while LIFO tends to result in lower net income taxes. The average cost method usually falls somewhere in between.

How Each Inventory Method Affects Cost and Profit

Let’s look at a real-life example. Suppose you manufacture leather handbags.

You purchase 100 pieces of leather for $20 per piece. Then, the next week, you buy 200 pieces of leather for $25 per piece. At the end of the next accounting period, you’ve sold 50 handbags. Here’s how the methods play out in each scenario:

Average Cost Method

100 pieces of leather at $20 per piece = $2,000

200 pieces of leather at $25 per piece = $5,000

Total number of pieces = 300

Average cost of manufacturing a handbag: $7,000 / 300 = $23.33 per bag

Cost of goods sold: $23.33 x 50 = $1,166.50

Remaining inventory value: $23.33 x 250 = $ 5,832.50

FIFO Method

Cost of goods sold: 50 handbags sold × $20 = $1,000

Remaining inventory value: (50 handbags × $10) + (200 chairs × $20) = $4,500

LIFO Method

Cost of goods sold: 50 handbags sold × $25 = $1,250

Remaining inventory value: (100 handbags × $20) + (150 chairs × $25) = $5,750

As you can see, the differences among the COGS calculations vary depending on which of the inventory valuation methods you choose. That, in turn, affects your profit during each accounting period.

The assumptions you make when choosing a method to calculate inventory do indeed change your outcome. So, make sure you choose the right one for your company.

Inventory Methods Allowed Under GAAP and IFRS

If you only do business in the United States, you can use the LIFO method, as well as FIFO and the average cost inventory method. The US uses the US Generally Accepted Accounting Principles (GAAP).

However, if you do business internationally, you cannot use the LIFO method. The International Financial Reporting Standards (IFRS) prohibit the LIFO approach. The IFRS accepts only the FIFO and average cost inventory valuation methods.

Which Inventory Method Is Right for You?

Which inventory method you need to choose depends on several variables. Use the following factors to guide you:

• Your business goals
• Your inventory profile
• Your tax strategy
• The size and complexity of your business
• Industry norms

LIFO

Eliminate this method if you do business internationally. However, if you only sell products within the United States, consider using LIFO if you:

• Need to save money on taxes in the short term
• Have a large inventory of non-perishable items
• Sell products whose prices rise each year
• Produce petroleum products, automobiles, or raw materials

FIFO

If you do business internationally, consider using FIFO. It’s the most common costing method worldwide.

However, it’s also worth considering if you run a US-based company. You could benefit from the FIFO method if your business:

• Sells perishable items
• Manufactures items that go out of style quickly
• Needs a system that’s easy to implement
• Wants to attract investors or lenders with higher profits
• Can weather short-term tax hikes

Average Cost

Out of all the inventory valuation methods, the weighted average cost method is by far the easiest to use. That factor alone makes it a good choice for smaller businesses. It also works well for larger companies that:

• Carry a large inventory with similar costs
• Cannot track individual items
• Handle raw materials whose prices fluctuate
• Experience seasonal ups and downs

Conclusion

In conclusion, choosing the best inventory costing method depends on a variety of factors. Those factors include the nature of your products, your financial goals, and the tax implications. Understanding the differences between these inventory valuation methods is crucial for accurate inventory valuation, financial reporting, and tax compliance.

Learn how inventory management software designed for the manufacturing industry can help your company reach its goals.

Reach out to the Eyelit Technologies team today to learn more!

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