The way you value your inventory has a direct impact on a number of elements in your financial statements. Accounting for inventory directly impacts assets reported on your balance sheet and cost of goods sold recorded on your income statement. As you sell an item from your inventory, it moves from an asset to an expense. It’s important to assign the correct dollar amount to inventory because this amount slowly converts to an expense and ultimately impacts your company’s bottom line. Analyzing the three main types of inventory valuation helps you decide which is most effective for your small business.
FIFO Method of Inventory Valuation
The First In, First Out (FIFO) method of inventory valuation assumes the earliest goods you purchase are the ones you sell first — first in, first out. Imagine that your business buys and sells folding chairs. On January 1, you purchase 250 chairs for $10 each. On January 4, you purchase another 200 chairs of the exact make for $8 each. On January 7, you sell 50 chairs. Under the FIFO method, you sold goods that were among the first to be purchased. In this case, the cost of the 50 chairs you sold is $10 per chair, since the earliest chairs you bought cost $10 each. The remaining 200 chairs at $10 each and 200 chairs bought at $8 each go on your balance sheet as inventory.
This inventory method is most beneficial for a small business during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest. Imagine you buy an item of inventory for $25. Six months later, you buy the same piece of inventory for $35. When one of the items is eventually sold for $50, the FIFO method dictates the cost of the good sold is $25. Therefore, the FIFO method is most advantageous when attempting to maximize net income.
Another advantage of the FIFO method is that it conceptually avoids obsolescence. Because you sell older inventory items first, inventory listings have a lower chance of reporting items too old to sell. However, there are drawbacks to the FIFO method. Income taxes are higher, and your company needs more cash to pay that bill. In addition, with FIFO, current period costs aren’t reported in the current period. This makes the financial statements slightly inaccurate. In the second example above, although you pay $35 for your product in the current period, the actual expense recognized is only $25. Therefore, you must manage cash flows more actively.
LIFO Method of Inventory Valuation
The opposite of the FIFO method is the Last In, First Out (LIFO) method of inventory valuation. With LIFO, the last inventory items bought are the first ones to be sold. Using the same figures from the chair example above, when recording the sale of 50 chairs under the LIFO method, you record that the chairs sold were the last ones bought. In this case, the cost of the chairs sold is $8. The remaining chairs — still 400 in total — are reported as 250 bought for $10 each and 150 bought at $8 each. Again, these remaining 400 chairs are reported as inventory.
When selecting the LIFO method in an inflationary period, your company’s tax bill is lower. This alleviates cash flow requirements and creates an unreported income tax deferral. Another advantage is the accuracy of the timing of expense recognition, as expenses are actually reported in the period they occur. In addition, if you want to avoid writing off the future value of inventory, you should opt for this method because inventory is already understated.
A potential downside to the LIFO method is that it typically reduces your net income compared to the FIFO method. In addition, future net income is higher, a fact a small business must understand and anticipate from an income tax standpoint. Another downside to the LIFO method is it may not align with the actual flow of goods in certain industries, such as the food industry, where perishable inventory is best managed under FIFO. A company that handles perishable goods needs to rotate stock and manage expiration dates, so it physically sells the oldest inventory goods first, assuming the products are still good.
Using the Weighted-Average Method
The weighted-average inventory valuation method applies the same inventory cost to every unit, regardless of the actual cost of each specific item. The clear benefit of the weighted-average method is its simplicity. You don’t need to track what you sell and when you sell it for inventory-costing purposes. Instead, you only maintain the total dollar amount of inventory and the quantity in stock for each inventory item. If you spend $4,100 on two orders that resulted in 450 chairs, the average price per chair is $9.11. Therefore, when you sell 50 chairs, the cost of these chairs is $9.11 per chair, and all remaining chairs in ending inventory have a cost of $9.11.
Another benefit of this method is standardized expenses across inventory batches. For example, if you have a manufactured batch that has higher than normal waste, the cost of that waste is allocated across all batches, keeping the cost of all items the same.
The weighted-average method does have disadvantages. It doesn’t match any inventory flow, and actual expenses are never explicitly assigned to the items sold. Net income reported under the weighted-average method always falls between the amount reported under FIFO and LIFO. Therefore, future tax benefits and cash flow advantages are minimized.
Impact of Valuation Methods on Financial Statements
In the examples above, the difference between the cost of goods sold under LIFO and FIFO was $2 per chair, for a total of $100 for the sale of 50 chairs. This means the cost of goods sold expense is $100 higher under FIFO. This results in net income being $100 less under FIFO, and there’s now less income to report on your taxes. In addition, this $100 difference is buried in the balance sheet. The cost of ending inventory under the LIFO method is $100 greater than under FIFO.
Considering Inflation When Choosing a Valuation Method
When operating in an inflationary economy, prices of goods purchased increase over time. This means net income is highest under the FIFO method because the cost of goods sold reflects the oldest prices. Meanwhile, inventory is highest under the LIFO method because the last items purchased — at the highest prices — are in inventory.
During inflationary times, average costing calculations produce cost of goods sold and inventory calculations in between the numbers produced under FIFO and LIFO.
How to Select an Inventory Method
When choosing an inventory valuation method, consider a few elements. First, you should identify the cash flow implications and evaluate what cash flow might look like in the next three to five years. Second, consider the impacts on your financial statements. Will you benefit most from having higher net income? Does your balance sheet need to report higher assets for financing purposes? Third, consider the actual flow of materials. The selection you make must be substantiated, an element especially important if your inventory flows in a specific manner, such as with perishables.
Ultimately, the FIFO, LIFO, and weighted-average inventory valuation methods grant your business flexibility in financial reporting. As a small business owner, you want to understand the implications of each method, and enjoy the benefit of having the freedom to choose which method works best for your business. You can efficiently track and report your inventory with robust accounting software. 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.