Average Cost Method vs FIFO vs LIFO
What is the difference between the average cost method, FIFO, and LIFO methods of inventory value calculation, and why does it matter? Inventory is a crucial component of a business’s financial statements, and it is essential to know how to calculate and record inventory costs. Inventory costs are important for managerial decision-making and for tax purposes, and there are different ways to calculate them, such as the average cost method, FIFO, and LIFO.
Average Cost Method
The average cost method is a method of inventory costing that calculates the average cost of all items in the inventory. To use this method, you need to 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. This value is then used to determine the cost of goods sold, ending inventory, and gross profit.
FIFO
FIFO stands for first in, first out and is a method of inventory costing that assumes the oldest items in inventory are sold first. This means that the cost of goods sold is calculated using the cost of the oldest items in inventory, while the ending inventory is calculated using the cost of the newest items in inventory.
LIFO
LIFO stands for last in, first out and is a method of inventory costing that assumes the newest items in inventory are sold first. Therefore, the cost of goods sold is calculated using the cost of the newest items in inventory, while the ending inventory is calculated using the cost of the oldest items in inventory.
Differences Between Average Cost Method, FIFO, and LIFO
The main difference between the average cost method, FIFO, and LIFO is the way they calculate the cost of goods sold and ending inventory. While the average cost method takes an average of all inventory items, FIFO and LIFO both use specific identification, which means they take the actual cost of specific items sold or remaining in inventory. Therefore, fluctuations in prices can affect the cost of goods sold and ending inventory differently depending on which method is used. Another difference between these methods is their effect on net income and tax liability. FIFO tends to result in higher net income and higher taxes, while LIFO tends to result in lower net income and lower taxes. The average cost method usually falls somewhere in between.
Conclusion
In conclusion, the choice of inventory costing method depends on a variety of factors, such as the nature of the products sold, the financial goals of the business, and the tax implications. Understanding the differences between these methods is crucial for accurate inventory valuation, financial reporting, and tax compliance.
