Inventory Valuation Methods

Recall the inventory equation:

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:

• Specific identification
• First in, first out (FIFO)
• Last in, first out (LIFO)
• Weighted Average Cost

Under US GAAP, all these methods are permitted. Under IFRS, LIFO method is not allowed.

Under these methods:

• The ending inventory in terms of units will be the same
• The COGS and cost of ending inventory will be different
• Purchase cost will be same
• If the costs are rising, LIFO results in lowest net income

We will take an example to explain inventory valuation under all four methods. Let’s say SuperMart reports the following transactions for June.

We will use this information to determine the cost of goods sold and the cost of ending inventory, under each cost flow method.

Specific Identification Method

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.

First-in, First-out (FIFO) Method

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

Cost of Goods Sold = 16,700

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

Cost of Ending Inventory = $27,100

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.

Last-in, First-out (LIFO) Method

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

Cost of Goods Sold = $18,300

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

Cost of Ending Inventory = $25,500

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.

Weighted Average Cost Method

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.

Average Unit Cost = 43,800/10,000 = $4.38

Cost of Goods Sold = 4,000 * $4.38 = $17,520

Ending Inventory = 6,000 * $4.38 = $26,280

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.