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Inventory Management

Dec 11, 2015

FIFO-LIFO | Average Cost Method of Accounting | Inventory

Inventory can be valued by using a number of different methods. The most common of these methods are the FIFO, LIFO and Average Cost Method...

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First-In-First-Out & Last-In-First-Out

Inventory can be valued by using a number of different methods. The most common of these methods are the FIFO, LIFO, Average Cost Method, and Specific Identification. Although these are not the only way to account for inventory value, we can briefly discuss the implications of how each method impacts the value of inventory with in your organization.

FIFO or First-in-First-out is most closely related to the flow of inventory through your organization. This is where the first items purchased are the first items sold or consumed during production.

LIFO or Last-in-First-out is a method that is closely tied with the current cost of a particular good as it represent what was most recently purchased and those are the items first to sell or be used.

Average Cost Method of accounting for inventory takes an average, as the name implies, of all of the costs of all of your inventory. It is calculated by dividing the total number of units you have on hand by the total cost of goods. You will arrive at an average unit cost for each unit of your inventory.

Specific Identification goes a step further than all of these in terms of accuracy and precision:  Every single unit of inventory gets an assigned ID or receiving timestamp, allowing the exact received value to remain associated with each individual unit of stock from the moment it arrives until it is sold or removed from your inventory.  If your organization usually enforces FIFO or LIFO, but not always in every scenario, Specific Identification is a great alternative as it allows for either of those strategies but also handles values properly if you deviate from it on occasion.

Depending on how you value your inventory or which method you use, you can arrive at different figures for the same events over a period of time. I know that may sound confusing, but take the example of FIFO accounting. Let’s say that your costs are rising as they so often do and each time you place an order, it costs more for the same amount purchased as the previous order. Since FIFO accounting requires you to sell the first item purchased first, your per unit cost will be lower than the last time you made a purchase, ultimately resulting in a higher profit margin. Conversely, if you use the LIFO method your profit margin will appear to be smaller even though the only thing that we changed is the method of accounting for the inventory. The Average Cost method will come somewhere between the two figures.

Unlike FIFO, LIFO, or Average Cost Method, the Specific Identification approach allows for flexibility in what order inventory is used without losing any accuracy in the value calculation.  For Specific Identification to be practical for the average small business, it requires powerful software that can do the legwork of assigning IDs and handling deduction of these as they are used automatically (it’s a lot of data to track otherwise!).

For businesses that use Zenventory to manage inventory and order fulfillment, any of these four methods is a viable option.  The standard inventory value reports included with Zenventory use the most accurate Specific Identification method by default, but easy integration is also available to common accounting platforms such as QuickBooks Online to support the FIFO, LIFO, or Average Cost Method.

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