First-In-First-Out & Last-In-First-Out
Inventory can be valued by using a number of different methods. The most common of these methods are the FIFO, LIFO, Average Cost Method, and Specific Identification. Although these are not the only way to account for inventory value, we can briefly discuss the implications of how each method impacts the value of inventory within your organization.
First-in-First-out (FIFO)
FIFO or First-in-First-out is most closely related to the flow of inventory through your organization. This is where the first items purchased are the first items sold or consumed during production.
Last-in-First-out (LIFO)
LIFO or Last-in-First-out is a method that is closely tied with the current cost of a particular good as it represent what was most recently purchased and those are the items first to sell or be used.
Average Cost Method
Average Cost Method of accounting for inventory takes an average, as the name implies, of all of the costs of all of your inventory. It is calculated by dividing the total number of units you have on hand by the total cost of goods. You will arrive at an average unit cost for each unit of your inventory.
Specific Identification
Specific Identification goes a step further than all of these in terms of accuracy and precision: Every single unit of inventory gets an assigned ID or receiving timestamp, allowing the exact received value to remain associated with each individual unit of stock from the moment it arrives until it is sold or removed from your inventory. If your organization usually enforces FIFO or LIFO, but not always in every scenario, Specific Identification is a great alternative as it allows for either of those strategies but also handles values properly if you deviate from it on occasion.
Depending on how you value your inventory or which method you use, you can arrive at different figures for the same events over a period of time. I know that may sound confusing, but take the example of FIFO accounting. Let’s say that your costs are rising as they so often do and each time you place an order, it costs more for the same amount purchased as the previous order. Since FIFO accounting requires you to sell the first item purchased first, your per unit cost will be lower than the last time you made a purchase, ultimately resulting in a higher profit margin. Conversely, if you use the LIFO method, your profit margin will appear to be smaller even though the only thing that we changed is the method of accounting for the inventory. The Average Cost method will come somewhere between the two figures.
FAQs
What is the difference between FIFO and moving average costing methods in valuing raw materials inventory?
The FIFO (First-In, First-Out) and moving average costing methods are used to value raw materials inventory, but they differ in their approach.
Under the FIFO method, the cost of goods sold (COGS) is calculated using the oldest inventory first, regardless of any recent changes in costs. Like we touched on above, this means that the cost of the oldest units in inventory is used to determine the value of ending inventory. For example, if a business purchased 100 units of inventory at $5 per unit and later bought 70 more units at $12 per unit, FIFO would calculate COGS based on the cost of the initial 100 units ($5 per unit) and the additional 50 units purchased at $12 per unit. The ending inventory value would then be based on the cost of the remaining units at the most recent purchase price.
On the other hand, the moving average costing method calculates COGS and ending inventory value by taking into account the average inventory value per unit. This method considers all units and their corresponding prices. For instance, using the example mentioned earlier, the moving average method would calculate the average inventory value. It does this by totaling the cost of all units (100 units x $5) and (70 units x $12), and then dividing this sum by the total number of units (170 units). This would result in an average inventory value per unit of $7.80. The COGS would then be calculated by multiplying the average inventory value per unit by the number of units sold (150 units x $7.80), and the ending inventory value would be based on the cost of the remaining units using the same average.
In summary, the FIFO method values the ending inventory based on the oldest units' cost, while the moving average method uses the average cost of all units.
Is FIFO Better Than LIFO?
Many businesses tend to choose FIFO for inventory valuation and accounting purposes. FIFO has certain advantages that make it a favorable choice for many.
One of the key reasons why FIFO is often preferred is that it allows for more accurate calculations. This method ensures that older inventory items are sold or used first, which reflects a more realistic depiction of the actual flow of goods. By valuing inventory based on the cost of the oldest items, FIFO provides a clearer picture of the current value of the remaining inventory.
Additionally, the management of FIFO is relatively easier compared to LIFO. With FIFO, businesses do not have to keep track of changing costs and revalue their inventory based on recent purchases or production costs. This simplified approach reduces the complexity of inventory management and saves time and effort for businesses.
Another significant benefit of FIFO is that it often yields higher profits, making it an attractive choice for e-commerce businesses seeking to appeal to investors. As older inventory items are usually recorded at lower costs, the sale of newer, higher-cost items leads to higher profits. This can contribute to making the business more lucrative and appealing to potential investors.
In conclusion, although both FIFO and LIFO are legitimate inventory valuation methods, FIFO is often considered better due to its accuracy, ease of management, and potential for higher profitability. Nevertheless, it is advisable to consult with a CPA or accounting professional to determine which method aligns most effectively with your specific business needs.
Final Thoughts
Unlike FIFO, LIFO, or Average Cost Method, the Specific Identification approach allows for flexibility in what order inventory is used without losing any accuracy in the value calculation. For Specific Identification to be practical for the average small business, it requires powerful software that can do the legwork of assigning IDs and handling deduction of these as they are used automatically (it’s a lot of data to track otherwise!).
For businesses that use Zenventory to manage inventory and order fulfillment, any of these four methods is a viable option. The standard inventory value reports included with Zenventory use the most accurate Specific Identification method by default, but easy integration is also available to common accounting platforms such as QuickBooks Online to support the FIFO, LIFO, or Average Cost Method.
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