Accounting Inventory Methods
Because almost every company has inventory of some kind, there exists the need for account inventory methods. There can be a number of different things that companies keep in inventory, such as the products they manufacture or materials that will be used during the product manufacturing process. Although there are different ways to account for inventory, most companies use one of three methods – “First-in, First-out,” commonly referred to as “FIFO,” “Last-in Last-out,” or “LIFO” or the Average Cost method. Keeping close tabs on a company’s inventory is an important accounting function, since it can be quite crucial to a company’s success or failure.
First-in, First-out (FIFO)
The FIFO method of inventory is based on the assumption that when a company sells a product or uses a raw material held in inventory to manufacture a product, they use the oldest item first. This means that as far as the company’s income statement is concerned, it assumes that the older inventory, which was probably cheaper, was used. The end result of this assumption is that the income is calculated to be higher, while the cost of the sale is lower. On the company’s balance sheet, this method of accounting translates into the assumption that the remaining inventory is newer, and thus more valuable, since it was probably more expensive. This method of inventory accounting is preferred by many companies, because its method of calculation associates the cost of the products that are sold more closely to the actual cost of the inventory. It’s also a more accurate way of calculating inventory for a company that deals in perishable food products or other kinds of products that have an expiration date or limited shelf life. This is because in these situations a company does sell the older products first, as well as usually using their oldest raw materials first.
Last-in, Last-out (LIFO)
The LIFO method of inventory is based on the assumption that when a product is sold from a company’s inventory, it’s the newest product that is sold first. This means that on a company’s income statement, it’s assumed that the newer inventory, which was probably more expensive, was used. The end result of this method of accounting is that the income is calculated to be lower, while the cost of the sale is higher. On the balance sheet, this translates into the assumption that the inventory that remains is older, and as such is less valuable. This method of accounting is also popular with many companies, because it closely aligns the cost of the products sold with the revenue of the company. However, this also assumes that the remaining inventory could possibly be outdated. In fact, some companies use this method of inventory accounting because it gains them tax deferrals.
Using this method of inventory, the average inventory cost is calculated and is then used for both the cost of inventory and sales. This means that on the income statement, the cost of income and sales will both be somewhere between the levels as they would have been recorded using either FIFO or LIFO. This is also true regarding the inventory asset level on the company’s balance sheet. This method tends to not be as currently popular with companies, as many have switched to either FIFO or LIFO because these methods can help them better deal with their rising costs.