Inventory Valuation Methods: FIFO, LIFO, and Weighted Average

Inventory Valuation Methods are among the most important accounting processes, one that directly affects the income statement and the balance sheet. Different Inventory Valuation Methods are used, and each method has its own impact on the cost of goods sold, net profit, and the value of inventory at the end of the period. In this article, we will discuss three of the most popular Inventory Valuation Methods: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average, with a detailed explanation of each method, stating its advantages and disadvantages, and clarifying how it affects the financial statements, and we will finally explain the relationship to inventory counting methods.

What is Meant by Inventory Valuation?

Inventory valuation is the process of determining the cost of goods remaining in inventory at the end of the financial period. This cost is an essential element in calculating the cost of goods sold, which in turn affects net profit. The value of inventory is also one of the most important current asset items that appears on the balance sheet.

Importance of Inventory Valuation:

• Determining the Cost of Goods Sold: Inventory Valuation Methods are used to calculate the cost of goods sold, which is subtracted from sales revenue to arrive at gross profit.
• Determining the Value of Inventory: Inventory Valuation Methods determine the value of goods remaining at the end of the financial period, which is shown as a current asset on the balance sheet.
• Impact on Net Profit: Inventory Valuation Methods directly affect an entity’s net profit, as the cost of goods sold affects gross profit and therefore net profit.
• Impact on Taxes: The calculated net profit affects the amount of taxes due on the entity.
• Decision-Making: Inventory valuation information helps management make decisions related to product pricing, determining reorder points, and evaluating the efficiency of inventory management.

Inventory Valuation Methods:

1. First-In, First-Out (FIFO):
   • Concept: This method assumes that the goods purchased or produced first are the first to be sold. Therefore, the cost of goods sold consists of the cost of the oldest units available in inventory, while ending inventory consists of the cost of the most recently purchased units.
   • Advantages:
     • Easy to understand and apply.
     • Gives an inventory value close to the market value, especially in times of inflation.
     • Leads to a higher profit in times of inflation compared to the LIFO method.
   • Disadvantages:
     • May overestimate net profit in times of inflation, as high sales revenues are matched with a relatively low cost of goods sold.
     • Leads to higher taxes in times of inflation compared to the LIFO method.
2. Last-In, First-Out (LIFO):
   • Concept: This method assumes that the goods purchased or produced last are the first to be sold. Therefore, the cost of goods sold consists of the cost of the most recently purchased units, while ending inventory consists of the cost of the oldest units available in inventory.
   • Advantages:
     • Reduces taxes in times of inflation, as high sales revenues are matched with a high cost of goods sold.
     • Better reflects cash flows in times of inflation.
   • Disadvantages:
     • May undervalue inventory in times of inflation, as inventory is valued at the cost of old units.
     • Leads to a lower profit in times of inflation compared to the FIFO method.
     • Not permitted under International Financial Reporting Standards (IFRS).
3. Weighted Average Method:
   • Concept: The cost of goods sold and ending inventory are calculated based on the weighted average cost of all units available for sale during the period.
   • Calculation:
     • Unit Cost = (Cost of Beginning Inventory + Cost of Purchases) / (Number of Units in Beginning Inventory + Number of Units Purchased)
     • Cost of Goods Sold = Number of Units Sold × Average Unit Cost
     • Cost of Ending Inventory = Number of Units Remaining × Average Unit Cost
   • Advantages:
     • Relatively easy to apply.
     • Gives results that are intermediate between FIFO and LIFO.
     • Reduces the impact of price fluctuations on the cost of goods sold and net profit.
   • Disadvantages:
     • May not accurately reflect the actual flow of goods.
     • May not be suitable for all types of businesses.

Numerical Example to Illustrate Inventory Valuation Methods:

Assume a company had 100 units in beginning inventory at a cost of 10 Riyals per unit, purchased 200 units at a cost of 12 Riyals per unit, and then sold 250 units during the period.

First: Using the First-In, First-Out (FIFO) method:

• Cost of Goods Sold:
  • (100 units × 10 Riyals) + (150 units × 12 Riyals) = 1000 + 1800 = 2,800 Riyals
• Cost of Ending Inventory:
  • 50 units × 12 Riyals = 600 Riyals

Second: Using the Last-In, First-Out (LIFO) method:

• Cost of Goods Sold:
  • (200 units × 12 Riyals) + (50 units × 10 Riyals) = 2400 + 500 = 2,900 Riyals
• Cost of Ending Inventory:
  • 50 units × 10 Riyals = 500 Riyals

Third: Using the Weighted Average method:

• Average Unit Cost: (1000 + 2400) / (100 + 200) = 3400 / 300 = 11.33 Riyals (approximately)
• Cost of Goods Sold: 250 units × 11.33 Riyals = 2,832.5 Riyals
• Cost of Ending Inventory: 50 units × 11.33 Riyals = 566.5 Riyals

Note: These examples show how different Inventory Valuation Methods can affect the cost of goods sold, net profit, and inventory value.

Relationship of Inventory Valuation Methods to Inventory Counting Methods:

It’s important to connect Inventory Valuation Methods with inventory counting methods. As mentioned earlier, there are two main types of inventory counting methods: periodic inventory and perpetual inventory.

• Periodic Inventory: Inventory is physically counted only at the end of the period, and therefore the cost of goods sold is calculated at the end of the period using the equation: Cost of Goods Sold = (Cost of Beginning Inventory + Cost of Purchases) – Cost of Ending Inventory (based on the physical count and the chosen valuation method). All Inventory Valuation Methods can be applied with periodic inventory.
• Perpetual Inventory: Inventory movement is tracked continuously, and the cost of goods sold is updated after each sale. All Inventory Valuation Methods can also be applied with perpetual inventory, but it should be noted that some accounting software may not support the LIFO method automatically.

Factors Influencing the Choice of Inventory Valuation Method:

• Applicable Accounting Standards: Applicable accounting standards (such as IFRS or GAAP) specify the permissible Inventory Valuation Methods.
• Nature of the Entity’s Business: The nature of the goods stored influences the choice of the appropriate method. For example, FIFO may be more suitable for perishable goods.
• Tax Impact: Inventory Valuation Methods affect the amount of taxes due, so some entities may choose the method that minimizes the tax burden.
• Cost of Implementing Each Method: The cost of implementing each of the Inventory Valuation Methods varies, especially with regard to the requirements of accounting software and systems used.
• Management’s Desire to Show Higher or Lower Profits: Some managements may tend to choose a method that leads to showing higher profits, while others may tend to show lower profits for tax purposes.

Role of Technology in Inventory Valuation:

Modern inventory management software and Enterprise Resource Planning (ERP) systems provide advanced capabilities for automatically applying different Inventory Valuation Methods, reducing human errors and saving time and effort. These systems help in:

• Tracking inventory movement accurately.
• Calculating the cost of goods sold correctly according to the chosen method.
• Generating detailed reports on inventory movement and valuation.
• Performing the necessary analyses to make better decisions about inventory management.

Conclusion:

Choosing the appropriate method for inventory valuation from the Inventory Valuation Methods is an important decision that affects the accuracy of financial data and the correctness of management decisions. Each entity should carefully study the different Inventory Valuation Methods (FIFO, LIFO, Weighted Average) and choose the method that suits the nature of its business and achieves its financial goals. Understanding Inventory Valuation Methods and how they affect financial statements is essential for every accountant and for anyone who uses financial information in decision-making. Mastering Inventory Valuation Methods enhances your skills in financial accounting and helps you succeed in the business world.