Does the choice of an inventory costing method impact a companys balance sheet?

Do you routinely analyze your companies, but don't look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets. As a result, inventory is a critical component of the balance sheet. Therefore, it is important that serious investors understand how to assess the inventory line item when comparing companies across industries or in their own portfolios.

Key Takeaways

• The Last-In, First-Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first.
• The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.
• LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock.
• FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.

What Is Inventory?

In general, when we speak of inventory, we are referring to a company's goods in three stages of production: 1) goods that are raw materials, 2) goods that are in production, and 3) goods that are finished and ready for sale. In other words, you take the goods that the company has in the beginning, add the materials that it purchased to make more goods, subtract the goods that the company sold, cost of goods sold (COGS), and the result is what remains—inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets, as inventory can be sold, thus turning it into cash in the near future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

BI+ Net Purchases −COGS=EIwhere:BI = Beginning inventoryEI = Ending Inventory\begin{aligned} &\text{BI} + \text{ Net Purchases } - \text{COGS} = \text{EI}\\ &\textbf{where:}\\ &\text{BI = Beginning inventory}\\ &\text{EI = Ending Inventory}\\ \end{aligned}​BI+ Net Purchases −COGS=EIwhere:BI = Beginning inventoryEI = Ending Inventory​

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Inventory: FIFO, LIFO

Understanding LIFO and FIFO

The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows. The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory–or the oldest inventory–is the sold first. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on the balance sheet).

Last-In, First-Out (LIFO)

The Last-In, First-Out (LIFO) method assumes that the last or moreunit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.

Average Cost

The average cost method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.

LIFO vs. FIFO: Inventory Valuation

The valuation method that a company uses can vary across different industries. Below are some of the differences between LIFO and FIFO when considering the valuation of inventory and its impact on COGS and profits.

LIFO

Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete. As a result, LIFO doesn't provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today's prices. Also, LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock while using the most recently acquired inventory.

For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products. In other words, the seafood company would never leave their oldest inventory sitting idle since the food could spoil, leading to losses.

As a result, LIFO isn't practical for many companies that sell perishable goods and doesn't accurately reflect the logical production process of using the oldest inventory first.

FIFO

FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most recently acquired items reflect current market prices. For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.

For example, the seafood company, mentioned earlier, would use their oldest inventory first (or first in) in selling and shipping their products. Since the seafood company would never leave older inventory in stock to spoil, FIFO accurately reflects the company's process of using the oldest inventory first in selling their goods.

LIFO and FIFO: Impact of Inflation

If inflation were nonexistent, then all three of the inventory valuation methods would produce the same exact results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, our bakery example from earlier would be able to produce all of its bread loaves at $1, and LIFO, FIFO, and average cost would give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period.

Assuming that prices are rising, inflation would impact the three inventory valuation methods as follows:

LIFO

When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from a lower tax liability.

FIFO

When sales are recorded using the FIFO method, the oldest inventory–that was acquired first–is used up first. FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS. However, the higher net income means the company would have a higher tax liability.

Average Cost

The average cost method produces results that fall somewhere between FIFO and LIFO.

However, please note that if prices are decreasing, the opposite scenarios outlined above play out. In addition, many companies will state that they use the "lower of cost or market" when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO, or average cost.

Example of LIFO vs. FIFO

In the tables below, we use the inventory of a fictitious beverage producer called ABC Bottling Company to see how the valuation methods can affect the outcome of a company’s financial analysis.

The company made inventory purchases each month for Q1 for a total of 3,000 units. However, the company already had 1,000 units of older inventory that was purchased at $8 each for an $8,000 valuation. In other words, the beginning inventory was 4,000 units for the period.

The company sold 3,000 units in Q1, which left an ending inventory balance of 1,000 units or (4,000 units - 3,000 units sold = 1,000 units).

ABC CO. — MONTHLY INVENTORY PURCHASESMonthUnits PurchasedCost / EachValueJan1,000$10$10,000Feb 1,000$12$12,000Mar1,000$15$15,000 3,000 = Total Purchased  

ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCHItemLIFOFIFOAverage CostSales = 3,000 units @ $20 each$60,000$60,000$60,000Beginning Inventory8,0008,0008,000Purchases37,00037,00037,000Ending Inventory  8,00015,00011,250COGS$37,000$30,000$33,750Expenses10,00010,00010,000Net Income$13,000$20,000$16,250

COGS Valuation

• Under LIFO, COGS was valued at $37,000 because the 3,000 units that were purchased most recently were used in the calculation or the January, February, and March purchases ($10,000 + $12,000 + $15,000).
• Under FIFO, COGS was valued at $30,000 because FIFO uses the oldest inventory first and then the January and February inventory purchases. In other words, the 3,000 units comprised of (1,000 units for $8,000) + (1,000 units for $10,000 or Jan.) + (1,000 units for $12,000 or Feb.)
• The average cost method resulted in a valuation of $11,250 or (($8,000 + $10,000 + $12,000 + $15,000) / 4).

Below are the Ending Inventory Valuations:

• Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that the last units in (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
• Ending Inventory per FIFO: 1,000 units x $15 each = $15,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
• Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)] / 4000 units = $11.25 per unit; 1,000 units X $11.25 each = $11,250. Remember that we take a weighted average of all the units in inventory.

LIFO or FIFO: It Really Does Matter

The difference between $8,000, $15,000 and $11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics—factors that expose a company's current financial health, and which enable us to make projections about its future, for example. So, which inventory figure a company starts with when valuing its inventory really does matter. And companies are required by law to state which accounting method they used in their published financials.

Although the ABC Company example above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO, or average cost can be complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage, can prevent a company from operating efficiently. For investors, inventory can be one of the most important items to analyze because it can provide insight into what's happening with a company's core business.

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