Which inventory method provides a better matching of current costs with sales revenue?

Read this section, which focuses on the four inventory costing methods and the impact each has on the financial statements. It is important to understand the impact of inventory valuation on your own company, and the companies that you partner with, sell to, buy from, and invest in.

Selecting an Inventory Method

When selecting an inventory method, managers should look at the advantages and disadvantages of each.

LEARNING OBJECTIVES

Summarize the differences between LIFO, FIFO, and Specific Identification and explain how a company would use that information to select an inventory method

KEY TAKEAWAYS

Key Points

• Specific identification provides the most precise matching of costs and revenues and is, therefore, the most theoretically sound method.
• The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value.
• During periods of inflation, LIFO shows the largest cost of goods sold (COGS) of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs.
• When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO.

Key Terms

• inventory: A detailed list of all of the items on hand.
• balance sheet: A summary of a person's or organization's assets, liabilities. and equity as of a specific date.

Advantages and Disadvantages of Specific Identification

Companies that use the specific identification method of ‘inventory costing' state their cost of goods sold and ending inventory as the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is therefore the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical. However, one disadvantage of the specific identification method is that it permits the manipulation of income.

Advantages and Disadvantages of FIFO

The FIFO method has four major advantages:

1. It is easy to apply.
2. The assumed flow of costs corresponds with the normal physical flow of goods.
3. No manipulation of income is possible.
4. The balance sheet amount for inventory is likely to approximate the current market value.

All the advantages of FIFO occur because when a company sells goods, the first cost it removes from inventory are the oldest unit costs. The cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income ([fig:11053]]). The disadvantages of FIFO include the recognition of paper profits and a heavier tax burden if used for tax purposes in periods of inflation.

An example of how to calculate the ending inventory balance of the period using FIFO - assume the following inventory is on hand and purchased on the following dates:

• Inventory of Product X –
• Purchase date: 10/1/12 - 10 units at a cost of USD 5
• Purchase date: 10/5/12 - 5 units at a cost of USD 6
• On 12/30/12, a sale of Product X is made for 11 units
• When the sale is made, it is assumed that the 10 units purchased on 10/1/12 and 1 unit purchased on 10/5/12 were sold
• The ending inventory balance on 12/31/12 balance sheet is 4 units at a cost of USD 6, or USD 24. The cost of goods sold on the income statement is USD 56 (10 units * USD 5 + 1 unit * USD 6).

Advantages and disadvantages of LIFO

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management ‘s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

An example of how to calculate the ending inventory balance of the period using LIFO - assume the following inventory is on hand and purchases are made on the following dates:

• Inventory of Product X –
• Purchase date: 10/1/12 - 10 units at a cost of USD 5
• Purchase date: 10/5/12 - 5 units at a cost of USD 6
• On 12/30/12, a sale of Product X is made for 11 units. When the sale is made, it is assumed that the 5 units purchased on 10/5/12 and 6 units purchased on 10/1/12 were sold.
• The ending inventory balance on 12/31/12, is 4 units at a cost of USD 5, or USD 20. The cost of good sold on the income statement is USD 60 (5 units * USD 6 + 6 units * USD 5).

Advantages and Disadvantages of Weighted-Average

When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The following is an example of the weighted average cost method:

• On 12/31/12, Furniture Palace has cost of goods available for sale of USD 5,000; 200 units available for sale; sales of 50 units; and an ending inventory of 150 units.
• The per unit cost of inventory is USD 25 (5,000 / 200 units). The value of the ending inventory on the balance sheet is USD 3,750 (150 units * USD 25). The cost of goods sold on the income statement is USD 1,250 (50 units * USD 25).