Which inventory costing method most closely matches the cost flow with the goods flow?

The accounting for the costs of inventory depends on the cost flow method you chose. The four ones in common use are last in, first out (LIFO), first in, first out (FIFO), specific identification and weighted average cost. Each method can give a different value to ending inventory, cost of goods sold and net income. A higher COGS creates a lower, though not necessarily realistic, net income and reduces taxes.

Reality

1. A company’s net income is “realistic” if it arises from a matching of COGS to revenues. Matching of costs and revenues is a central feature of accrual accounting under generally accepted accounting principles. Since net income appears on the income statement, the realistic method is the one in which costs most closely tie to revenues for the period. You might get a different answer if you ask which method gives you the most realistic ending inventory -- it should give an answer that values ending inventory at current values and thus provides the most realistic view of the company’s balance sheet assets.

LIFO

1. Under LIFO, you make believe you sell your most recently purchased inventory items first. The real inventory flow might bear no resemblance to the cost flow -- you might actually sell your oldest items first and still adopt LIFO for accounting purposes. LIFO gives the most realistic net income value because it matches the most current costs to the most current revenues. Since costs normally rise over time, LIFOs can result in the lowest net income and taxes.

FIFO

1. GAAP also allows the FIFO method, which assumes you sell your inventory items as if they were stored in a queue. You sell the oldest inventory items ahead of the most recent ones. This doesn’t fit well with GAAP requirements for realistic net income since you match obsolete prices with the most current revenues. Conversely, FIFO gives you the timeliest value for ending inventory, since the unsold items reflect the most current costs. In periods of rising prices, FIFO leads to the highest income and taxes.

Other Methods

1. Specific identification of the cost and revenue for each inventory item gives the most realistic values for COGS and ending inventory. However, this might not be the case for net income if you purchase identical items at different prices. Your choice of which one you sell might be random and thus not satisfy the matching principle. For example, if you receive three shipments of identical diamond earring sets at different prices, you might be able to identify each specific earring set. Nevertheless, if you sell the oldest one first, your haven’t matched current costs to revenues. The weighted average cost method gives realistic net income only if you purchase all available-for-sale units of the same merchandise item at identical prices.

Small business accountants can use one of four distinct inventory costing methods to account for the cost of goods sold. Different inventory costing methods are best suited to different situations and financial goals, and no single method is inherently better than any other. Small business owners should understand the different types of inventory costing methods and the advantages of each to select the best method for their accounting system.

First In, First Out

The first in, first out method most closely approximates the real-world purchasing cycle and parallels the actual flow of inventory from purchase to sale in a wide range of businesses. Under the FIFO method, the oldest costs are assigned to inventory items sold, regardless of whether the sold items were actually purchased at that cost. When the number of inventory items purchased at the oldest cost is sold, the next oldest cost is assigned to sales.

For example, if a company buys 10 widgets at $20 each, then buys 10 more at $19 each, the company would assign the $20 cost to the first 10 widgets it sells, then begin to assign the $19 cost.

Last In, First Out

The last in, first out method is the exact opposite of the FIFO method, assigning the most recent inventory costs to items sold. Last in, first out is less practical in most businesses, but there are a few specific situations in which LIFO more closely approximates the actual flow of inventory. Consider gravel yards, for example, which dump new loads of gravel on top of a pile consisting of several older loads. When a gravel yard sells a load, it takes the materials from the top of the pile – the most recently purchased inventory.

Using the example above under the LIFO method, a company would assign the newest cost of $19 to the first 10 units sold, then move on to the $20 cost, assuming it had not made another purchase in the meantime.

Average Cost Method

The average cost method assigns inventory costs by calculating a moving average of all inventory purchase costs. This method can be ideal for companies that sell non-perishable inventory in a non-sequential manner, such as video game retailers. The average cost method can also provide a more steady, reliable cost recognition structure than other methods, assuming costs do not swing wildly up and down for inventory items.

To continue the example above under the average cost method, a company would assign an average cost of $19.50 – the sum of 20 and 19 divided by 2 – to all 20 widgets sold.

Specific Identification Method

The specific identification method perfectly matches inventory costs with units sold, assigning the exact cost of each sold inventory item when the specific item is sold. This method is not suited for businesses that sell high volumes of relatively homogenous products, such as food producers, but it can be ideal for companies that sell high-dollar items with relatively low volume, such as automobiles or yachts.

Consider a car lot, for example. When a salesperson sells a car, he can forward the exact VIN or invoice number of the car to the accounting department along with the sales information, allowing accountants to look up exactly how much the dealership paid for the car.

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