Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
Today’s article is the third (and final) in a mini-series covering the basic accounting concept of 'Inventory'. In this mini-series we have looked at the fundamentals of inventory, focusing on both the ‘count’ side of things, the quantities, as well as cost models for inventory valuation. We also learned the valuable concept of ‘when inventory’ becomes the owner’s property. Today we are going to look at a comparative analysis of 'average cost', 'FIFO' and 'LIFO'.
The last time we examined the concepts associated with 'average cost' in an environment in which perpetual inventory costs are changing over time. We used our old friend 'the dongle' from our 'Accounting 101' (mini-series) business to help us learn these essential principles. Today we want to look beyond 'average cost' to the other two most common cost methodologies FIFO and LIFO.
While Part 2 looked at average cost of inventory, our example actually only looked at acquisition of the inventory. We didn’t look at any inventory sales, but in today’s example we want to start out looking a what happens when we sell some inventory in order to examine how sales, as well as purchases, impact average cost. Then we will focus on the exact same scenarios using FIFO and LIFO costing.
Let’s look back at our beginning inventory as valued last time. Remember each little block represents a case of 25 ‘dongles’.
Inventory 101 - Part 3 - fig 1
We now have a total of 250 dongles, worth $327.50, so each dongle has an average cost of $1.31.
If we sell 200 dongles from the 250 dongles we have available, the we only have 50 dongles remaining.
The value of our 200 (dongles) cost of goods sold = 200 @$1.31 or $262.00, that means our remaining inventory of 50 dongles is worth $65.50. So in this scenario our ending inventory is $65.50.
Now we want to apply the same principal to both FIFO (First-in, First-out) and LIFO (Last-in, First-out) inventory cost accounting methodologies.
First-in, First-out (FIFO) Inventory Costing
For our First-in, First-out (FIFO) illustration we still have the exact same ‘starting inventory’ and purchased inventory scenario.
Inventory 101 Part 3 - figure 2
And we are going to use the same ‘sales’ situation in which we sell 200 dongles from our total inventory available of 250 dongles. But this time we are going to apply our math in FIFO costing format.
In order to sell 200 dongles using FIFO we must first include our original 100 dongles.
Inventory 101 Part 3 - figure 3
Notice that our total COGS under FIFO is $2.00 less than under ‘average cost’. This means that our ending inventory of 50 dongles, which are each valued at 1.35 represent an ending inventory value of $67.50; in this case our ending inventory is worth $2.00 more than under ‘average cost.’
The explanation is simple, under First-in, First-out we sold (on a cost basis) our older lower cost inventory first before starting to sell our higher-cost inventory, and at the end we ended with inventory that was valued at the higher (later) cost. Now let’s look at what happens when we use the third method of inventory cost valuation.
By the way, Zoho Books uses the First-in, First-out (FIFO) method of inventory cost valuation.
Last-in, First-out (LIFO)
Last-in, First-out (LIFO) takes, from a cost perspective, just the opposite approach as FIFO, when we sell inventory we sell the most recently purchased leaving older stock on the shelf*. Once again we begin with the exact same inventory situation as in our average cost and FIFO examples.
Inventory 101 Part 3 - figure 2
But in this case, in order to sell 200 dongles using LIFO we sell the entire 150 dongles from our most recent purchases valued at $1.35/dongle.
Inventory 101 - Part 3 - figure 4
Observe that our total COGS under FIFO is $3.00 more than under ‘average cost’, and $5.00 more than under ‘FIFO’.
This means that our ending inventory of 50 dongles, which are each valued at the original inventory stock cost of 1.25 represent an ending inventory value of $62.50.
A Comparison of Average Cost, FIFO and LIFO
So let’s look at a comparative chart that illustrates all 3 cost methodologies.
Inventory 101 Part 3 - figure 5
It is important to realize that each of these ‘cost methods’ entails cash-flow assumptions only, it actually has no physical relationship to the actual flow of products either being purchased or being sold. Cost methods are separate and apart from any ‘specific identification’ methods of inventory receipt or distribution such as lot tracking or expiration tracking.
The results shown in the comparative chart above are consistent with the general concept that LIFO produces the highest cost-of-goods sold (assuming rising prices), and thus lowest gross profit; while FIFO produces the highest cost-of-goods sold, and thus the highest gross profit. Some accounting theorists will argue that LIFO enhances both Financial Statement presentations, as well as producing lower taxes resulting from a lower gross profit. The basis for this argument centers on the fact that LIFO most closely matches recently incurred costs with recently generated revenues.
Each inventory-centric business will need to determine, with the assistance of their Accountant and/or Tax Advisor, which inventory cost valuation methodology will best work for them. Hopefully this mini-series have given you enough information to help you understand these methods, and potentially implement the solution you and your trusted advisors agree on.