The Battle of Cost Flow Methods: LIFO, FIFO and Average Cost
Welcome to the world of procurement and inventory cost flow methods! As a business owner or manager, you want to make sure that your company is utilizing the best cost flow method for its financial success. But with different options like LIFO, FIFO, and Average Cost method available, it can be challenging to choose which one suits your business model best. In this blog post, we will delve into each of these cost flow methods’ advantages and disadvantages so that you can make an informed decision on which one works best for your company’s needs. So let’s jump right in!
What are cost flow methods?
Cost flow methods are accounting techniques used to determine how a company records the cost of goods sold and ending inventory. As a business owner, it is essential to understand the different cost flow methods available and choose one that best suits your company’s needs.
The first cost flow method is LIFO or Last-In-First-Out. This method assumes that the last items purchased are the first ones sold, making older inventory costs remain in ending inventory. This approach can be beneficial during times of inflation as it reduces taxable income by matching high-priced goods with revenues.
The second method is FIFO or First-In-First-Out, which operates under the assumption that the oldest products purchased were also the first ones sold. FIFO ensures that older inventories’ costs are matched against revenue, resulting in higher taxable income during periods of inflation.
There is Average Cost Method where all units’ average price (total purchase price divided by total number of units) from beginning stock and purchases throughout an accounting period will be used for both COGS (costs incurred on producing product) and Ending Inventory value calculation.
Understanding each cost flow method’s advantages and disadvantages will help you make informed decisions about choosing one for your business model.
LIFO method
LIFO or Last in, First out is a cost flow method that assumes the most recently acquired inventory items are the first ones sold. This means that the cost of goods sold reflects current prices and is typically higher than other methods.
The LIFO method can be advantageous during times of inflation because it reduces taxable income by matching high-priced purchases with sales revenue. It also allows businesses to maintain lower carrying costs for older inventory items.
However, LIFO may not accurately reflect actual inventory values since it assumes that the oldest items on hand are always accounted for last, regardless of their true value. Additionally, using LIFO can result in reduced profits during times of deflation as well as potential difficulty when trying to compare financial statements across different companies or industries.
Choosing whether or not to use the LIFO method depends on various factors such as business needs, industry standards and government regulations.
FIFO method
The FIFO method, or First-In-First-Out, is another commonly used cost flow method for inventory accounting. This method assumes that the first items purchased are the first ones sold or used in production.
Under this method, companies must keep track of their inventory purchases and sales transactions to determine the cost of goods sold (COGS) and ending inventory. The COGS formula under FIFO is calculated by multiplying the cost per unit of the oldest items in inventory by the number of units sold.
One advantage of using FIFO is that it generally results in a higher reported net income during periods when prices are rising because older, lower-cost items are being matched with current higher selling prices.
However, one disadvantage is that if there’s a sudden increase in demand for products, businesses may have to purchase newer stock at significantly higher costs than what they would have paid earlier. This could lead to inflated profits during times where there’s inflation happening within an industry.
Deciding which cost flow method to use depends on various factors such as business type and its goals. Companies should evaluate each option before selecting one that best suits them while also ensuring compliance with any applicable financial reporting standards.
Average Cost method
The Average Cost method is a cost flow approach that assigns the average cost of all units available for sale during a certain period to both the ending inventory and the sold units. This method determines an average unit cost by dividing the total costs of goods available for sale by total units available.
One advantage of this method is its simplicity, as it only requires one calculation at the end of each accounting period. Unlike LIFO or FIFO, it doesn’t require tracking individual lot numbers or dates of purchase/sale.
Another benefit is that it smooths out fluctuations in purchase prices over time. The use of an average unit cost means that inventory values are less affected by sudden changes in material costs, which can happen frequently in some industries.
However, one drawback is that fluctuations in purchasing prices may mean you’re not valuing your inventory accurately if there are significant price differences between older and newer purchases.
Ultimately, whether this method works best for your business depends on various factors such as industry norms and financial goals. It’s crucial to examine all options before deciding on one particular approach.
Advantages and disadvantages of each method
Advantages and disadvantages of each cost flow method should be carefully considered before implementing one in your business.
LIFO (Last In, First Out) method is advantageous for businesses facing inflation as it reduces tax liabilities by assuming higher costs on newer inventory items sold first. However, this can lead to inaccurate valuation of older inventory items that are left unsold and may result in lower reported profits.
FIFO (First In, First Out) method assumes that the oldest inventory items are sold first, making it ideal for industries with perishable goods or those constantly updating their products. This results in a more accurate valuation of ending inventory but may lead to higher tax liabilities due to reporting higher profits.
Average Cost Method calculates the average cost per unit over all units available for sale during the period making it useful when valuing similar products with little variation between them. It also simplifies record-keeping processes as there is no need to track individual purchases and sales prices. However, fluctuations in purchasing prices can cause fluctuations in COGS which may not accurately reflect market conditions.
It’s essential to weigh these advantages and disadvantages against your specific business needs before deciding which cost flow method best suits your company’s operations.
Which cost flow method is best for your business?
Choosing the best cost flow method for your business depends on various factors such as the nature of your products, market demand, and financial goals.
For example, if you deal with perishable goods or fast-moving consumer goods (FMCG), FIFO might be a suitable option as it ensures that the oldest inventory is sold first. This way, you can avoid spoilage or obsolescence costs and keep up with customer demands.
On the other hand, if you have a business that deals with non-perishable goods like machinery or electronics where newer inventory has higher value than older ones, LIFO may be advantageous as it reduces tax liability by accounting for current prices rather than old ones.
Meanwhile, average cost method is ideal for businesses that sell homogeneous products at uniform prices throughout its lifecycle because it provides an accurate valuation of ending inventory without much fluctuation in profit margins.
Ultimately, choosing which method to use must also consider how each affects financial statements such as balance sheets and income statements. It’s important to consult an accountant before making any decisions.
Conclusion
After carefully examining the three cost flow methods for inventory, it is clear that each has its own set of advantages and disadvantages. LIFO may be advantageous during times of inflation as it can reduce tax liability, but FIFO may provide a more accurate representation of current inventory costs. The Average Cost method offers a middle ground between the two.
Ultimately, choosing the best cost flow method for your business will depend on various factors such as industry standards, financial goals, and inventory management practices. It is important to carefully consider each option before making a decision.
By understanding the differences between these cost flow methods and their potential impact on your business’s finances, procurement professionals can make informed decisions about how to handle their company’s inventory costs. With this knowledge in hand, businesses can stay competitive in an ever-changing market while maintaining strong financial health.