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Inventory Costing Methods
How companies account for inventory movement results
in different balance sheet and cost of sales values. Inventory items can be
traced by actual specific identification cost, by an average cost per item,
by “FIFO” costing (first in first out), or “LIFO” costing (last in first
out). All of these methods, plus others, are valid approaches in the attempt
to match product revenues with the appropriate product cost of sales.
FIFO vs. LIFO
The FIFO inventory method leaves the latest
purchases, thus the most recent costs, in inventory. This results in the
earlier items and associated costs being considered as sold first.
The LIFO costing method results in the earlier
purchases and their associated costs being considered as remaining in
inventory; the current period’s cost of sales represents the latest cost. In
an inflationary period, this can result in inventory valuation on the
balance sheet being understated, when compared with current fair market
values. LIFO allows companies to “manage earnings” by liquidating inventory
layers that have lower associated costs. “Eating” into old layers can result
in higher gross profit margins than the current market is bearing,
distorting the basic principle of matching revenues with appropriate
expenses.
In an
inflationary environment FIFO results in the highest profit, while LIFO
results in the lowest inventory value. The balance sheet differential
between FIFO and LIFO inventory book values is referred to as the LIFO
reserve. Most investors don’t consider this to be an issue any longer,
as inflation is relatively stable.
Click here for information on:
-Focus on the Profit Margins
-Perpetual vs. Periodic Inventory
-Inventory Accounting Calculation
-Lower of Cost or Market
-Inventory Categories
-Inventory Turnover Ratios |
