Which inventory valuation method best matches the cost of goods sold with current replacement cost?

In some cases, it's possible to specifically identify which inventory items have been sold and which remain. Using the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold; Credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items. In most cases, companies may be unable to determine exactly which items are sold and which items remain in ending inventory. The remaining three methods are referred to as cost flow assumptions under GAAP and cost formulas under IFRS. They should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory. Weighted Average Cost Using the weighted average cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

• Average cost = (beginning inventory + purchases) / units available for sale
• Ending inventory = average cost x units of ending inventory
• COGS = cost of goods available for sale - ending inventory

• Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, the cost of inventory may be decades old and almost useless for analysis purposes. However, the cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement costs. As a result, LIFO provides a better measurement of current income and future profitability.
• Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement costs. The gain is actually holding gain or inventory profit. It is debatable whether this should be considered income; at least, analysts can say the underestimated COGS leads to inflated net income.

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How Each Inventory Cost Method Works

When inventory is interchangeable, meaning you have many identical items, you don’t need to track each item individually (e.g., 10,000 identical toy cars vs. 100 uniquely customized real cars). Instead, you value each group of items as a whole using one of the following methods.

First In, First Out (FIFO)

The FIFO method removes your oldest items from inventory first. If you bought 10 items in January at $1, 10 more in April at $2, and 10 more in July at $3, then sold 15 total during the year, your cost of goods sold would be $20. The first 10 items you bought cost $1 each ($10 total), and the next five cost $2 each ($10 total). Your remaining inventory (the 15 unsold items) would be valued at 5 x $2 + 10 x $3 = $40.

FIFO gives you the advantage of having your stated inventory value (what's available for sale) closely match current prices.

Last In, First Out (LIFO)

LIFO is the opposite of FIFO. Your newest items come out of inventory first. In the above example, your cost of goods sold is now $40 — the last 10 items you bought cost $3 each ($30 total), and the five before that cost $2 each ($10 total). Your remaining inventory would be based on the first 15 items you bought for a value of 10 x $1 + 5 x $2 = $20.

With LIFO, your costs of goods sold (what you already sold) closely matches current prices. Because costs generally rise, LIFO also allows you to deduct a larger cost from your taxes and lowers potential write-downs from unsold inventory.

Average

The average cost method takes your average cost during the period and assigns it to all items. In the above example, the average purchase price is $2. The cost of goods sold for your 15 sold items is $30. The inventory value for your unsold 15 items is also $30.

The primary benefit to the average cost method is that it smooths out price fluctuations.

One More Consideration: Cost or Market?

In general, inventory value should reflect the value of the item to your business.

In areas such as manufacturing and bulk-goods retail, where inventory prices may shift but actual value doesn’t, it's often proper to only consider the cost you paid. For example, you may need 25 nails to build a piece of furniture, and fluctuations in nail prices or what you paid for individual nails don’t really affect your end product.

In some cases, market value needs to be considered. Electronics is the most common example. If your store bought the latest smartphone wholesale at $400 and the manufacturer cuts the wholesale price to $300 when they release a new model, you’ll either have to reduce your retail prices or be undercut by competitors. Even if you paid $400 for your unsold inventory, it’s no longer worth that much, and reporting it at that cost would overstate your inventory and overall assets.

The general accounting principle to follow is conservatism. You should take the most conservative approach when preparing your books. In the context of inventory that changes in value (other than routine up-and-down price swings), you should value your inventory at the lower of your cost or the current market value.

Which Inventory Method to Choose?

Your ideal inventory costing method may vary based on what you are valuing the inventory for. Remember, it is generally permissible to use different methods on your tax returns and financial statements prepared for investors or managers.

For Taxes

The IRS provides three options for valuing inventory: identifying specific items, FIFO or LIFO. If you are not using LIFO, you may be required to report the lower of cost or market value.

If you expect your costs to continually rise, the LIFO method typically provides the largest deduction because the newest, and presumably most expensive, inventory is deducted first.

While you are free to select the most advantageous method when you first file taxes, you must use the same method each year. You may not switch between FIFO and LIFO from year to year simply because one offers a larger deduction in the current year.

For Financial Statements

All three inventory cost methods are typically allowed under Generally Accepted Accounting Principles, but you should check for specific provisions related to your operations. If you operate or seek investments internationally and need to follow International Financial Reporting Standards, you may not use the LIFO method.

If your goal is to show larger profits and more assets on your financial statements, you want to reduce your costs of goods sold and increase your inventory value. Assuming that costs generally rise, FIFO will typically be more advantageous.

You are free to change methods from year to year, but you must identify the method you used, and investors will want to see an explanation for changes in inventory methods.

For Management Decisions

When making management decisions, you want to see if your operations are sustainable under both current and historic prices. While you don’t want to overreact to short-term fluctuations, you also don’t want high costs to be masked in an overall average.

Consider having your controller services prepare inventory and costs of good sold reports using all three methods so you can see both the optimistic and pessimistic outlooks.

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