Which of the given inventory valuation method best matches the cost of goods sold and the replacement cost?

The three most widely used methods for inventory valuation are First-In, First-Out (FIFO) Last-In, First-Out (LIFO) Weighted Average Cost

Inventory valuation method is the way to calculate the total value of the inventory owned by a company at any particular time. The inventory value is calculated based on the total cost incurred in purchasing the inventory and getting it ready for sale in the market.

This is important in accounting where the valuation of any item plays a part in calculating Cost of Goods Sold and has a direct effect on the income statement & balance sheet.

In this article, we have explained the different inventory valuation methods with examples.

How Inventory Is Valued

The three most widely used methods for inventory valuation in accounting are:

1. First-In, First-Out (FIFO)
2. Last-In, First-Out (LIFO)
3. Weighted Average Cost

First-In, First-Out (FIFO)

According to the first-in-first-out (FIFO) valuation method, the inventory items are sold in the same order in which they are purchased or manufactured. The oldest inventory products are sold first as per the FIFO method. The FIFO valuation method is the most commonly used inventory valuation method as most of the companies sell their products in the same order in which they purchase it.

FIFO Valuation: Example 1

FIFO Valuation: Example 2

Let’s say a business bought Laptops at different timing and prices.

First transaction- Ten laptops at $1,000 each

Second transaction- Five laptops at $1,100 each

At the end of the month, the store had sold eight laptops.

With the FIFO valuation method, costing is calculated from the first transaction when the user purchased ten laptops at $1,000 each.

So, after selling eight laptops:

Accounting balance for COGS = (8 laptops x $1,000 each) = $ 8,000

Two laptops are still left from the first purchase, cost at $1000 each, as well as the five laptops from the second purchase at $1,100 each. So:

Accounting balance of  Inventory account = (2 laptops x $1,000 cost) + (5 laptops at $1,100 cost) = $7,500

Last-In, First-Out (LIFO)

The last-in-first-out (LIFO) inventory valuation method is precisely the opposite of the FIFO valuation method. It assumes that the most recently purchased or manufactured items are sold first.

LIFO Valuation: Example 1

LIFO Valuation: Example 2

Let’s say a business bought laptops at different timing and prices.

First transaction- Ten laptops at $1,000 each

Second transaction- Five laptops at $1,100 each

After selling 2 laptops:

Accounting balance for COGS = (2 laptops x $1,100 LIFO cost) = $2,200

Ten laptops are still left from the first purchase, cost at $1,000 each, as well as the three laptops from the second purchase at $1,100 each. So:

Accounting balance of  Inventory account = (3 laptops at $1,100 cost) + (10 laptops at $1,000 cost) = $13,300

Weighted Average Cost (or Avg Cost)

With the Weighted Average Cost inventory valuation method, inventory, and Cost of Goods Sold (COGS) are calculated based on the average cost of all items purchased during a period. This method is mainly used by businesses that don’t have variation in their inventory.

Weighted Avg Cost Valuation: Example 1

Weighted Avg Cost Valuation: Example 2

Let’s say a business bought Laptops at different timing and prices.

First transaction- Ten laptops at $1,000 each

Second transaction- Five laptops at $1,100 each

Here you have a total of 15 laptops, which you paid $15,500 for in total (10,000 + 5,500)

So, your weighted average cost would be the $15,500 cost divided by the 15 laptops, which is 1,033.33 per laptop.

After selling 13 laptops:

Accounting balance for COGS = (13 laptops x $1,033.33 average cost) = $13,433.33

Accounting balance of  Inventory account = (2 laptops remaining x $1,033.33 average cost) = $2,066.67

In the above examples, we saw how the FIFO, LIFO and Weighted Avg Cost methods impact the accounting balances of COGS and Inventory accounts. Consequently, it impacts the income statement which uses the COGS account as an input, and the balance sheet which uses the Inventory account as an input.

Because purchase/cost prices generally keep rising over a period of time, income statements for companies which follow inventory valuation with FIFO usually show lower COGS and hence higher profit.

Summing It Up

Choosing the right inventory valuation method is crucial as it has a direct impact on the business’s profit margin and accounting practices. Your choice of inventory valuation method can lead to a big difference in the cost of goods sold for your business. To choose the right inventory valuation method for your company, consider the factors such as your business location, your business costs, and your inventory amount.

Most businesses prefer using the FIFO method as it gives you a real picture of your costs and profitability. The FIFO method gives you more accurate information as it assumes the older inventory items are less costly and are the ones sold first. Also, the FIFO method provides you with the highest profit as the first items in stock are often the cheapest. As a business owner, analyze all the three methods and choose the method that suits your specific business situation.

Did You Know

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