Inventory Valuation Methods: FIFO, LIFO, and Weighted Average

Inventory valuation significantly influences both the balance sheet and the income statement. The method selected affects cost of goods sold (COGS), gross profit, taxable income, and financial ratios. Let's understand the mechanics, implications, and reporting requirements for the major inventory valuation methods—FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and Weighted Average Cost

Overview of Major Inventory Valuation Methods

Three primary methods are widely used in practice:

• FIFO (First-In, First-Out): Assumes the oldest inventory items are sold first, with remaining inventory valued at the most recent costs.

• LIFO (Last-In, First-Out): Assumes the newest inventory is sold first, so ending inventory consists of the oldest costs. (Allowed under US GAAP, not IFRS.)

• Weighted Average Cost: Inventory and COGS are determined by averaging the cost of all units available for sale during the period.

Each method can yield different results for COGS, net income, and taxes, especially when purchase costs are volatile.

FIFO Method

FIFO assumes the earliest goods purchased are the first sold. This means:

• COGS reflects older (potentially lower) costs during periods of rising prices.

• Ending Inventory is reported at more recent (higher) costs, providing a balance sheet value closer to current replacement cost.

Example:

• 100 units purchased at $10, 100 more at $12.

• 120 units sold: COGS = (100 × $10) + (20 × $12) = $1,000 + $240 = $1,240

• Ending inventory = (80 × $12) = $960

LIFO Method

LIFO assumes the most recently purchased items are sold first. This results in:

• COGS reflecting the latest (potentially higher) costs in inflationary periods, lowering taxable income.

• Ending Inventory valued at oldest (lower) costs, potentially understating asset values during rising price environments.

Example:

• Using the same data as above:

• 120 units sold: COGS = (100 × $12) + (20 × $10) = $1,200 + $200 = $1,400

• Ending inventory = (80 × $10) = $800

LIFO is permitted under US GAAP but prohibited under IFRS.

Weighted Average Cost Method

This method averages the cost of all units available for sale. Both COGS and ending inventory are valued at this average cost.

Example:

• Total cost: (100 × $10) + (100 × $12) = $1,000 + $1,200 = $2,200

• Total units: 200

• Weighted average cost per unit: $2,200 / 200 = $11

• 120 units sold: COGS = 120 × $11 = $1,320

• Ending inventory = 80 × $11 = $880

Comparison: Effects on Financial Statements

• During rising prices:

  • FIFO: Lower COGS, higher net income, higher ending inventory, higher taxes.

  • LIFO: Higher COGS, lower net income, lower ending inventory, lower taxes.

  • Weighted Average: Results fall between FIFO and LIFO.

• During falling prices: Effects are reversed.

Choice of method also impacts financial ratios such as gross profit margin, current ratio, and inventory turnover.

Disclosure Requirements and Consistency

• Companies must disclose the inventory valuation method used, changes in method, and the financial statement impact.

• Consistency is required across periods, but changes are allowed if they improve financial reporting (with retrospective application and disclosure).

LIFO Reserve:

Under US GAAP, companies using LIFO must disclose the difference between inventory under LIFO and FIFO/average cost (the “LIFO reserve”) for comparability.

Relevant Accounting Standards

• US GAAP: ASC 330 – Inventory

• IFRS: IAS 2 – Inventories (LIFO not permitted)

Summary Table: Inventory Valuation Methods

Method	COGS in Rising Prices	Ending Inventory Value	Allowed by US GAAP	Allowed by IFRS
FIFO	Lower	Higher	Yes	Yes
LIFO	Higher	Lower	Yes	No
Weighted Average Cost	Middle	Middle	Yes	Yes

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