Inventory valuation

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Inventory valuation, in accounting, refers to a methodology whereby inventory on hand is valued after a portion of it is sold or is otherwise removed.

There are various methods which are commonly used to value inventory: the most common are specific identification, FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost.

Specific Identification

Under this method, each inventory item is given a specific identification number, and when that item is sold it is removed from inventory.

This method is used only on large-ticket items which can be separately identified, such as houses and cars.

Example

The developer of Eagles Landing, a subdivision, has completed three houses but has not yet sold them:

Address Cost
101 Bald Eagle Boulevard $150,000
102 Golden Eagle Way $155,000
103 Spotted Eagle Street $159,000

The developer's inventory would show $464,000 in housing inventory.

Then, the developer sells the house at 103 Spotted Eagle Street. The inventory would be reduced by $159,000 (the cost to build that house) for remaining inventory of $305,000. If the developer then completes a house at 104 Bald Eagle Boulevard for $150,000, the inventory is increased to $455,000.

FIFO

Under FIFO, items are removed from inventory based on the oldest purchase cost shown in the accounting records. This method generally tracks how inventory is actually sold or removed, especially for items with short shelf lives (such as produce). This method is generally preferred when the cost of that product is declining, since because it removes the most expensive (earliest) entries first, it thus reduces the overall book value of product the most.

Example

The owners of God's World Garden Center sell SuperPlant, a premium plant food. The current SuperPlant inventory as of the end of the fiscal year (for this example, December 31) is as follows:

Purchase Date Number Cost
October 10 $10
November 10 $12
December 10 $14

The inventory value as of the end of the fiscal year is $360.

During January, the Eagles Landing Garden Club purchases five units of SuperPlant, the only sale during the month. Under FIFO, the five items sold are removed at $10 each (the oldest cost); the remaining inventory is valued as follows: (5 units x $10) + (10 units x $12) + (10 units x $14) = $310.

LIFO

Under LIFO, items are removed from inventory based on the oldest purchase cost shown in the accounting records.

This method was very popular since, due to inflation, it tends to reduce income for tax purposes. LIFO is still allowable for reporting purposes under United States Generally Accepted Accounting Principles and for tax purposes, but under international accounting rules it is no longer allowable.

Example

Using the garden center example above, under LIFO the five items sold are removed at $14 each (the newest cost); the remaining inventory is valued as follows: (10 units x $10) + (10 units x $12) + (5 units x $14) = $290.

Weighted Average Cost

Under this method, items are removed from inventory based on a weighted average of all purchase costs shown in the accounting records.

The weighted average can be calculated one of two ways:

  • One method is to calculate the average at the beginning of the year, use it throughout the year, then adjust the average at year-end to account for inventory shrinkage and purchases throughout the year.
  • The other method is to continually calculate the average to account for purchases and sales throughout the year, with a final adjustment at year-end to account for inventory shrinkage (this method is also called "moving average"). With the advent of computerized inventory and accounting software this method is the most commonly used.

Example

Using the garden center example above, the weighted average cost at the beginning of the year is as follows: (10 units x $10) + (10 units x $12) + (10 units x $14) = $360 / 30 units = $12/unit.

When the five units are sold, they are removed at $60 (5 units @ $12 each), and the remaining inventory valuation is $300 (25 units x $12 average cost). Under a moving average method, if the center purchases 15 more units at $14 each (total $210), the valuation is now $510, with 40 units in stock; the new weighted average is $12.75 per unit.