These methods are used to value inventory and determine the cost of goods sold (COGS). They are critical for financial reporting, taxation, and internal management.
1. FIFO (First-In, First-Out)
Concept:
The first items purchased (oldest inventory) are assumed to be sold first.
Remaining inventory consists of the most recently purchased items.
Use Case:
Common in businesses where inventory items are perishable or have an expiration date (e.g., food or pharmaceuticals).
Example:
Date | Units Purchased | Cost per Unit | Units Sold |
Jan 1 | 100 | $10 | 50 |
Jan 5 | 100 | $12 |
COGS for 50 Units Sold: 50 × $10 = $500.
Remaining Inventory: 50 units @ $10 + 100 units @ $12.
Advantages:
Matches physical flow of goods in many cases.
Results in lower COGS and higher profits during inflation (higher tax liability).
Disadvantages:
Not ideal during inflation as it may overstate profits.
2. LIFO (Last-In, First-Out)
Concept:
The last items purchased (newest inventory) are assumed to be sold first.
Remaining inventory consists of the oldest items.
Use Case:
Common in industries with non-perishable goods and where companies aim to reduce taxable income during inflation.
Example:
Date | Units Purchased | Cost per Unit | Units Sold |
Jan 1 | 100 | $10 | 50 |
Jan 5 | 100 | $12 |
COGS for 50 Units Sold: 50 × $12 = $600.
Remaining Inventory: 100 units @ $10 + 50 units @ $12.
Advantages:
Higher COGS during inflation, leading to lower taxable income.
Matches current costs with current revenues.
Disadvantages:
Results in lower profits during inflation.
Not allowed under IFRS (International Financial Reporting Standards).
3. AVCO (Average Cost Method)
Concept:
The cost of inventory is averaged, and each unit sold or remaining is valued at the average cost.
Formula:
Average Cost per Unit = Total Units Available/Total Cost of Inventory
Use Case:
Suitable for industries where inventory is indistinguishable (e.g., grains, liquids, or fuel).
Example:
DateUnits PurchasedCost per UnitTotal CostJan 1100$10$1,000Jan 5100$12$1,200
Total Units: 200.
Total Cost: $2,200.
Average Cost per Unit: $2,200 ÷ 200 = $11.
COGS for 50 Units Sold: 50 × $11 = $550.
Remaining Inventory: 150 units @ $11.
Advantages:
Smoothens out price fluctuations.
Simple to calculate and apply.
Disadvantages:
Less accurate in matching current costs with revenues.
Not reflective of actual physical inventory flow.
Comparison
Feature | FIFO | LIFO | AVCO |
COGS During Inflation | Lower | Higher | Moderate |
Ending Inventory Value | Higher | Lower | Moderate |
Profitability | Higher | Lower | Moderate |
Use in IFRS | Allowed | Not Allowed | Allowed |
Each method suits different business models and financial strategies.