Inventory Management

Inventory: U.S. Army unit badges from a wall of military uniform items.

First In, First Out (FIFO)

FIFO means that the oldest inventory items are recorded as sold first but does not necessarily mean that the exact oldest physical object has been tracked and sold. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first served (FCFS) behavior, where the persons leave the queue in the order they arrive or wait their turn at a traffic control signal.

Last In, First Out (LIFO)

LIFO means that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies have shifted toward using LIFO, which reduces their income taxes during times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States.

LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.

Average Cost

The average cost method is straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Two commonly used average cost methods are the simple weighted average cost method and the moving average cost method.

Weighted Average Cost Method

This method divides the cost of goods available for sale by the total amount of goods from beginning inventory and purchases, giving a weighted average cost per unit. A physical count is performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by the weighted average cost per unit to estimate the ending inventory cost.

Moving Average Cost Method

Assume we know the beginning inventory and the beginning inventory costs. We can use these to calculate the cost per unit of beginning inventory.

Several purchases are made during the year. Add the purchase costs to the beginning inventory cost each time to get the cost of the current inventory.

Similarly, add the number of units bought to the beginning inventory to determine the current goods available for sale.

After each purchase, divide the cost of the current inventory by the current goods available for sale to get the current cost per unit of goods.

Meanwhile, several sales occur during the year. The current goods available for sale are deducted from the number of goods sold, and the cost of the current inventory is deducted by the number of goods sold times the latest (before this sale) current cost per unit of goods.

Add this deducted amount to the cost of goods sold. At the end of the year, we can use the last cost per unit of goods, along with a physical count, to determine the ending inventory cost.