<p>In this course, we will discuss the various methods for valuing inventory, namely, LIFO, FIFO and weighted average cost method. The measurement of inventory cost is important because it is one of the largest current assets in most firms and is also a crucial factor for determining the gross profits of the firm. We will also learn about how each inventory measurement method affects a firm’s financial ratios.</p>

Inventories

Before we begin, let’s review the various types of inventory and the inventory equation. For a merchandising firm, the inventory is usually the finished goods which they store for sale. For manufacturing units, the inventory will be in the form of raw material, work-in-progress, and finished goods.

At the beginning of the financial year, a firm will have certain inventory with it. This is the beginning inventory. Then the firm will make purchases during the year, and some goods will be sold during the year. At the end of the year, the firm is left with some inventory. This is the ending inventory. A firm will use one of the inventory valuation methods, as we will discuss later, to calculate the cost of goods sold (COGS) and the cost of ending inventory. This can be expressed in the form of a simple accounting equation as follows:

<img class="aligncenter size-full wp-image-20972" src="https://financetrain.com/wp-content/uploads/inv1.gif" alt="Inventory" width="605" height="32" />

Note that there are four variables and you can rearrange this equation to calculate any of these variables.

Cost of Goods Sold (COGS) is reported in Income Statement and Ending Inventory is reported in Balance Sheet.

Inventory - Introduction

While accounting for inventories it is important to determine the costs that should be included in the inventory. The costs that are included in the inventories are called inventoriable costs or product costs and are capitalized and shown in the inventory account on the balance sheet. This is done because expenses must be matched against the revenue they produce. A manufacturer does not incur costs of production until the goods are sold.  Before that time, the costs are capitalized, that is, part of inventory as an asset. Inventories of manufactured goods should include all costs incurred to manufacturer and prepare them for sale, including:
<ul>
	<li>Materials used in the manufacturing process,</li>
	<li>Labor of manufacturing workers, and</li>
	<li>A portion of overhead that related to manufacturing.</li>
</ul>
When the goods are sold, the costs are released from inventory as expenses (typically called COGS) and matched against sales revenue.

There are certain costs that are not capitalized, and are instead recognized as expense in the year in which they are incurred. These are called period costs. These costs include:
<ul>
	<li>Selling and administrative expenses</li>
	<li>Storage costs</li>
	<li>Abnormal waste (of materials, labor or overheads)</li>
</ul>
Some examples of period costs are advertising, executive salaries, sales commissions, public relations, and other nonmanufacturing costs. For manufacturing companies, period costs include all non-manufacturing costs such as research and development, distribution, sales, etc. For service companies, all of their costs are period costs.

Costs Included in Inventory

Recall the inventory equation:

<img class="aligncenter size-full wp-image-20972" src="https://financetrain.com/wp-content/uploads/inv1.gif" alt="Inventory" width="605" height="32" />

If the cost of inventory remained constant over time, then the valuation of inventories would be very simple. We will simply multiply the number of units sold with the cost of each unit to calculate the cost of goods sold (COGS). Similarly the value of ending inventory would be the number of units in inventory multiplied by the cost of each unit. However, in reality, the cost of inventory changes over time, and we must choose an inventory valuation method to allocate the various costs to COGS (income statement) and ending inventory (balance sheet). These methods are called cost flow methods.

The four inventory valuation methods are:
<ul>
	<li>Specific identification</li>
	<li>First in, first out (FIFO)</li>
	<li>Last in, first out (LIFO)</li>
	<li>Weighted Average Cost</li>
</ul>
Under US GAAP, all these methods are permitted. Under IFRS, LIFO method is not allowed.

Under these methods:
<ul>
	<li>The ending inventory in terms of units will be the same</li>
	<li>The COGS and cost of ending inventory will be different</li>
	<li>Purchase cost will be same</li>
	<li>If the costs are rising, LIFO results in lowest net income</li>
</ul>
We will take an example to explain inventory valuation under all four methods. Let’s say SuperMart reports the following transactions for June.
<table>
<tbody>
<tr>
<td width="111"><strong>Date</strong></td>
<td width="397"><strong>Purchases (Sales) </strong></td>
<td width="108"><strong>Balance</strong></td>
</tr>
<tr>
<td width="111"><strong>1</strong></td>
<td width="397">Beginning inventory (@ $3.80)</td>
<td width="108">500</td>
</tr>
<tr>
<td width="111"><strong>2</strong></td>
<td width="397">Purchased 1,500 units (@ $4.00)</td>
<td width="108">2000</td>
</tr>
<tr>
<td width="111"><strong>14</strong></td>
<td width="397">Purchased 6,000 units (@ $4.40)</td>
<td width="108">8000</td>
</tr>
<tr>
<td width="111"><strong>20</strong></td>
<td width="397">Sold 4,000 units</td>
<td width="108">4000</td>
</tr>
<tr>
<td width="111"><strong>30</strong></td>
<td width="397">Purchased 2,000 units (@ $4.75)</td>
<td width="108">6000</td>
</tr>
</tbody>
</table>
We will use this information to determine the cost of goods sold and the cost of ending inventory, under each cost flow method.
<h3>Specific Identification Method</h3>
Under this method, each item purchased or sold is matched to its actual cost. This method works best with items that are unique, high cost, with small numbers held as inventory. For example, jewellery or cars can be valued using specific identification method.

The main advantage of this method is that it matches actual costs with revenue. The disadvantage is that it may be expensive to implement/maintain and may also lead to income manipulation.
<h3>First-in, First-out (FIFO) Method</h3>
Under this method, the costs of the oldest items in inventory are used to compute the cost of goods sold (COGS) expense on a company’s income statement.

FIFO ending inventory for the balance sheet is calculated based on values of the most recent inventory goods purchased.

In our example, 4,000 units were sold. The cost of these 4,000 units will be the cost of the oldest items.

500 units * $3.80 = $1,900

1,500 units * $4.00 = $6,000

2,000 units * $4.40 = $8,800

<strong>Cost of Goods Sold = 16,700</strong>

The ending inventory will be the value of most recently purchased goods.

4,000 units * $4.40 = $17,600

2,000 units * $4.75 = $9,500

<strong>Cost of Ending Inventory = $27,100</strong>

The main advantage of this method is that it tries to approximate the physical flow of goods and the value of ending inventory is close to the current cost. However, the disadvantage is that the current costs are not matched to the revenues. The cost of goods sold is based on oldest items, which is matched with the current sale price. If the prices increase rapidly, this will lead to a distortion of profits.
<h3>Last-in, First-out (LIFO) Method</h3>
Under this method, the costs of the newest inventory items are used to compute the COGS expense on the income statement.

LIFO ending inventory for the balance sheet is calculated based on values of the first inventory goods purchased.

In our example, 4,000 units were sold. The cost of these 4,000 units will be the cost of the newest items.

2,000 units * $4.75 = $9,500

2,000 units * $4.40 = $8,800

<strong>Cost of Goods Sold = $18,300</strong>

The ending inventory will be the value of oldest purchased goods.

4,000 units * 4.40 = $17,600

1,500 units * 4.00 = $6,000

500 units * 3.80 = $1,900

<strong>Cost of Ending Inventory = $25,500</strong>

An advantage of LIFO method is that it matches more recent costs with current revenues. The disadvantage is that in rising price scenario it results in lowest net income and understates ending inventory. Unlike FIFO, it does not approximate the physical flow of goods. Under IFRS, LIFO method is not allowed.
<h3>Weighted Average Cost Method</h3>
Under the weighted average cost method, an average cost per unit of inventory is calculated by adding the cost of beginning inventory and all purchases during the period, and dividing it by the total units available. This average cost is then used to compute the COGS and the ending inventory.
<table>
<tbody>
<tr>
<td width="111"><strong>Date</strong></td>
<td width="293"><strong>Purchases</strong></td>
<td width="212"><strong>Total Cost</strong></td>
</tr>
<tr>
<td width="111"><strong>1</strong></td>
<td width="293">Beginning inventory 500 units (@ $3.80)</td>
<td width="212">$1,900</td>
</tr>
<tr>
<td width="111"><strong>2</strong></td>
<td width="293">Purchased 1,500 units (@ $4.00)</td>
<td width="212">$6,000</td>
</tr>
<tr>
<td width="111"><strong>14</strong></td>
<td width="293">Purchased 6,000 units (@ $4.40)</td>
<td width="212">$26,400</td>
</tr>
<tr>
<td width="111"><strong>30</strong></td>
<td width="293">Purchased 2,000 units (@ $4.75)</td>
<td width="212">$9,500</td>
</tr>
<tr>
<td width="111"><strong>Total</strong></td>
<td width="293">Total Units = 10,000</td>
<td width="212">$43,800</td>
</tr>
</tbody>
</table>
<strong>Average Unit Cost = 43,800/10,000 = $4.38</strong>

<strong>Cost of Goods Sold = 4,000 * $4.38 = $17,520</strong>

<strong>Ending Inventory = 6,000 * $4.38 = $26,280</strong>

The advantage of this method is that it is easy to apply, objective, and not as subject to income manipulation. The disadvantage is that the recent costs are reflected in COGS, and older costs are reflected in inventory.

Inventory Valuation Methods

<h3>Inflation and Inventory Accounting Analysis</h3>
<strong>LIFO income statement in a rising price environment</strong> – LIFO method will lower reported margins.  Most recent goods are the most expensive and LIFO will calculate higher COGS and thus a lower gross profit.

<strong>LIFO balance sheet in a rising pricing environment</strong> – LIFO method lowers the value of inventory and thus the value of short term assets reported on the balance sheet.

<strong>FIFO income statement in a rising price environment</strong> – FIFO method will increase reported profit margins.  Oldest goods are the least expensive and FIFO will calculate lower COGS and thus a higher gross margin.

<strong>FIFO balance sheet in a rising pricing environment</strong> – FIFO method raises the value of inventory, as the least expensive items are taken off the balance sheet first
<h3>Deflation and Inventory Accounting Analysis</h3>
<strong>LIFO income statement in a falling price environment</strong> – LIFO method will raise reported margins.  Most recent goods are the least expensive and LIFO will calculate lower COGS and thus a higher gross margin.

<strong>LIFO balance sheet in a falling pricing environment</strong> – LIFO method raises the value of inventory because the cheapest items have been taken off the balance sheet first.

<strong>Example:</strong> If an analyst knows that a company employs LIFO and the prices of its goods have fallen due to weakening market demand, then the analyst may look to revise the balance sheet based on FIFO, as the real value of the company’s short-term assets is likely over-stated.

<strong>FIFO income statement in a falling price environment</strong> – FIFO method will lower reported margins.  Oldest goods are the most expensive because prices have fallen over time and FIFO will calculate higher COGS and thus a lower gross margin.

<strong>FIFO balance sheet in a falling pricing environment</strong> – FIFO method lowers the value of inventory, as the oldest and most expensive items are taken off the balance sheet first.
<h3>LIFO, FIFO, and Economic Reality</h3>
<strong>FIFO and the Balance Sheet</strong> – Regardless of an inflationary or deflationary environment, FIFO should best approximate the fair market value of balance sheet inventory as the value is based on more recent prices; the oldest goods have been sold out of inventory under FIFO.

<strong>LIFO and the Income Statement</strong> – Regardless of an inflationary or deflationary environment, LIFO should best approximate a company’s current gross profit performance.  The most recent goods purchased have been applied to cost of goods sold and this best approximates the company’s near term inventory replacement cost.

Inventory Accounting Analysis and Inflation/Deflation

A company can account for changes in inventory using either periodic inventory system or perpetual inventory system.

In the perpetual system, the company maintains a continuous record of inventory changes. All the purchases and sales of inventory are directly recorded in the inventory account. For every sale, the COGS is debited and inventory is credited.

In the periodic system, the company updates inventory records only periodically. All inventory purchases are debited to purchase account. The cost of goods sold and inventory values are determined at the end of the period. At the end of the period, we add purchases to the beginning inventory to arrive at the cost of goods available for sale. Then we subtract ending inventory to calculate COGS.

Under FIFO and specific identification methods, the values for COGS and ending inventory will be same in both perpetual and periodic inventory system. However, they will differ in LIFO and average cost methods.
<h3>Example</h3>
We will use the same example of SuperMart.
<table>
<tbody>
<tr>
<td width="111">Date</td>
<td width="397">Purchases (Sales)</td>
<td width="108">Balance</td>
</tr>
<tr>
<td width="111"><strong>1</strong></td>
<td width="397">Beginning inventory (@ $3.80)</td>
<td width="108">500</td>
</tr>
<tr>
<td width="111"><strong>2</strong></td>
<td width="397">Purchased 1,500 units (@ $4.00)</td>
<td width="108">2000</td>
</tr>
<tr>
<td width="111"><strong>14</strong></td>
<td width="397">Purchased 6,000 units (@ $4.40)</td>
<td width="108">8000</td>
</tr>
<tr>
<td width="111"><strong>20</strong></td>
<td width="397">Sold 4,000 units</td>
<td width="108">4000</td>
</tr>
<tr>
<td width="111"><strong>30</strong></td>
<td width="397">Purchased 2,000 units (@ $4.75)</td>
<td width="108">6000</td>
</tr>
</tbody>
</table>
Our earlier calculations of COGS and Ending inventory were based on periodic inventory system. We will now recalculate the same under perpetual inventory system using FIFO and LIFO methods.
<h3><strong>FIFO Perpetual System</strong></h3>
The COGS and Ending inventory are the same in FIFO perpetual system as in FIFO periodic system.

On June 20, 4000 units were sold. The COGS will be calculated as follows:
<table>
<tbody>
<tr>
<td width="154"><strong>Units</strong></td>
<td width="154"><strong>From</strong></td>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Cost</strong></td>
</tr>
<tr>
<td width="154"><strong>500</strong></td>
<td width="154">June 1 Beginning inventory</td>
<td width="154">500 units * $3.80</td>
<td width="154">$1,900</td>
</tr>
<tr>
<td width="154"><strong>1,500</strong></td>
<td width="154">June 2 purchase</td>
<td width="154">1,500 units * 4.00</td>
<td width="154">$6,000</td>
</tr>
<tr>
<td width="154"><strong>2,000</strong></td>
<td width="154">June 14 purchase</td>
<td width="154">2,000 units * $4.40</td>
<td width="154">$8,800</td>
</tr>
<tr>
<td colspan="3" width="462"><strong>FIFO COGS</strong></td>
<td width="154"><strong>$16,700</strong></td>
</tr>
</tbody>
</table>
On June 30, there are 6,000 units in inventory. The ending inventory will be calculated as follows:
<table>
<tbody>
<tr>
<td width="154"><strong>Units</strong></td>
<td width="154"><strong>From</strong></td>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Cost</strong></td>
</tr>
<tr>
<td width="154"><strong>4000</strong></td>
<td width="154">June 14 purchase</td>
<td width="154">4,000 units * $4.40</td>
<td width="154">$17,600</td>
</tr>
<tr>
<td width="154"><strong>2,000</strong></td>
<td width="154">June 30 purchase</td>
<td width="154">2,000 units * $.75</td>
<td width="154">$9,500</td>
</tr>
<tr>
<td colspan="3" width="462"><strong>FIFO Ending Inventory</strong></td>
<td width="154"><strong>$27,100</strong></td>
</tr>
</tbody>
</table>
<h3><strong>LIFO Perpetual System</strong></h3>
On June 20, 4000 units were sold. The COGS will be calculated as follows:
<table>
<tbody>
<tr>
<td width="154"><strong>Units</strong></td>
<td width="154"><strong>From</strong></td>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Cost</strong></td>
</tr>
<tr>
<td width="154"><strong>4000</strong></td>
<td width="154">June 14 purchase</td>
<td width="154">4000 units * $4.40</td>
<td width="154">$17,600</td>
</tr>
<tr>
<td colspan="3" width="462"><strong>LIFO COGS</strong></td>
<td width="154"><strong>$17,600</strong></td>
</tr>
</tbody>
</table>
On June 30, there are 6,000 units in inventory. The ending inventory will be calculated as follows:
<table>
<tbody>
<tr>
<td width="154"><strong>Units</strong></td>
<td width="154"><strong>From</strong></td>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Cost</strong></td>
</tr>
<tr>
<td width="154"><strong>500</strong></td>
<td width="154">June 1 Beginning inventory</td>
<td width="154">500 units * $3.80</td>
<td width="154">$1,900</td>
</tr>
<tr>
<td width="154"><strong>1,500</strong></td>
<td width="154">June 2 purchase</td>
<td width="154">1,500 units * 4.00</td>
<td width="154">$6,000</td>
</tr>
<tr>
<td width="154"><strong>2000</strong></td>
<td width="154">June 14 purchase</td>
<td width="154">2,000 units * 4.40</td>
<td width="154">$8,800</td>
</tr>
<tr>
<td width="154"><strong>2000</strong></td>
<td width="154">June 30 purchase</td>
<td width="154">2,000 units * $.75</td>
<td width="154">$9,500</td>
</tr>
<tr>
<td colspan="3" width="462"><strong>LIFO Ending Inventory</strong></td>
<td width="154"><strong>$26,200</strong></td>
</tr>
</tbody>
</table>
Note that the COGS and Ending inventory under Perpetual LIFO are different from periodic LIFO.

Perpetual Vs. Periodic Inventory Systems

We discussed the impact of <a title="Inventory Valuation Methods" href="https://financetrain.com/inventory-valuation-methods/">LIFO and FIFO valuation methods</a> on COGS, ending inventory, and gross profits under the increasing prices scenario under <a title="Inventory Accounting Analysis and Inflation/Deflation" href="https://financetrain.com/inventory-accounting-analysis-inflationdeflation/">inflationary and deflationary scenarios</a>. The following table summarizes the impact of LIFO and FIFO under the inflationary scenario (rising prices).
<table>
<tbody>
<tr>
<td width="205"><strong> </strong></td>
<td width="205"><strong>FIFO</strong></td>
<td width="205"><strong>LIFO</strong></td>
</tr>
<tr>
<td width="205"><strong>COGS</strong></td>
<td width="205">Lower</td>
<td width="205">Higher</td>
</tr>
<tr>
<td width="205"><strong>Ending Inventory</strong></td>
<td width="205">Higher</td>
<td width="205">Lower</td>
</tr>
<tr>
<td width="205"><strong>Gross Profits</strong></td>
<td width="205">Higher</td>
<td width="205">Lower</td>
</tr>
</tbody>
</table>
&nbsp;

Impact of Inventory Valuation Methods

International and U.S. accounting standards require companies to carry inventory on the balance sheet at the lower of cost or market (LCM).

With LCM an unrealized loss caused by a change that materially disconnects the in the fair market value of current inventory from the most recently reported book value of inventory must be immediately recognized.

This will lower the book value of assets on the balance sheet and reduce profit.

<strong>Example:</strong> The feature music file sharing device sold by an electronics chain has just become obsolete due to the advances offered by a new device that is not sold by this chain.  Regardless of inventory accounting method, the electronics chain must write down its inventory and take a write down charge on its income statement to more accurately reflect true financial position and performance.

Internationally (IFRS-IAS), net realizable value represents the cost to finalize and sell inventory.

In the US (GAAP), market value is generally estimated as the present replacement cost of the inventory.

Inventory at Net Realizable Value

Under <a title="Differences in IFRS and US GAAP Frameworks" href="https://financetrain.com/differences-in-ifrs-and-us-gaap-frameworks/">US GAAP and IFRS</a>, companies are required to make the following disclosures about inventory.
<ul>
	<li>Accounting policies for measuring inventories, including cost formulas used</li>
	<li>Total carrying amount of inventories</li>
	<li>Carrying amount of inventories carried at fair value less costs to sell</li>
	<li>Amount of inventories expensed during the period</li>
	<li>Amount of any write-downs expensed in the period</li>
	<li>Amount of any reversal of any write-down</li>
	<li>Circumstances leading to reversals of write-downs</li>
	<li>Carrying amount of inventories pledged as securities for liabilities</li>
</ul>

Disclosures Relating to Inventories

The following table summarizes the impact of <a title="Inventory Valuation Methods" href="https://financetrain.com/inventory-valuation-methods/">LIFO and FIFO inventory methods</a> on selected financial ratios.
<table width="610">
<tbody>
<tr>
<td><strong>FINANCIAL STATEMENT/RATIO</strong></td>
<td><strong>FIFO</strong></td>
<td><strong>LIFO</strong></td>
</tr>
<tr>
<td><strong>Net Income and Profit Margins</strong></td>
<td>Usually higher in a rising price environment.</td>
<td>Usually lower in a rising price environment.</td>
</tr>
<tr>
<td><strong>Pre-tax Cash Flow</strong></td>
<td>Same.</td>
<td>Same.</td>
</tr>
<tr>
<td><strong>After-tax Cash Flow</strong></td>
<td>Usually lower in a rising price environment because a company is reporting higher net income due to lower COGS.</td>
<td>Usually higher in a rising price environment because a company is reporting lower net income due to higher COGS.</td>
</tr>
<tr>
<td><strong>Current Ratio = Current Assets/Current Liabilities</strong></td>
<td>Usually higher in a rising price environment because reported inventories are more valuable and COGS is lower.</td>
<td>Usually lower in a rising price environment because reported inventories are based on lower cost purchases and higher COGS.</td>
</tr>
<tr>
<td><strong>Inventory Turnover = COGS/Avg. Inventory</strong></td>
<td>Usually lower in a rising price environment because the average cost of inventory will be higher.</td>
<td>Usually higher in a rising price environment because the average cost of inventory will be lower.</td>
</tr>
<tr>
<td><strong>Debt-to-Equity Ratio = Total Interest Bearing Debt/Total Shareholders’ Equity</strong></td>
<td>Usually lower in a rising price environment.</td>
<td>Usually higher in a rising price environment.</td>
</tr>
<tr>
<td><strong>Return on Assets
=Net Income/ Avg. Total Assets
Return on Equity
= Net Income / Avg. Total Equity</strong></td>
<td>Usually higher in a rising price environment because net income is higher.</td>
<td>Usually lower in a rising price environment because net income is lower.</td>
</tr>
</tbody>
</table>

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