An important part of running a company is being able to accurately report financial statements to the respective interested parties at the end of each quarter or financial year. A component of the financial assets or liabilities of the company is its inventory and the costs associated with what was sold or what remains. Therefore, it is essential to be able to value your inventory correctly. We shall take a closer look at some of the most common ways (called cost flow assumptions) that achieve this.
First-In-First-Out or FIFO is, as the name suggests, valuing the inventory that’s left based on the assumption that the first stock items to be receipted are the first items to be sold. This is a simplistic way of explaining it, but if we put it into an example, it might make more sense.
A clothing company is selling T-shirts and has receipted 20 T-shirts that cost $5 each and then a further 20 T-shirts that have now gone up to $7 each. They sold 30 T-shirts in the year for a stagnant price of $10 each and they had overheads of $50. Under a FIFO cost flow assumption, the older T-shirts that cost $5 each are the ones to be sold first with the newer ones remaining in inventory. The following information is relevant to the financial statement:
- Initial Inventory: $100 (20 T-Shirts x $5)
- Purchases: $140 (20 T-shirts x $7)
- Sales: $300 (30 T-shirts x $10)
- Cost of Goods Sold (COGS): $170 (20 T-shirts x $5 + 10 T-shirts x $7)
- Ending Inventory: $170 (10 T-shirts x $7)
- Expenses/Overheads: $50 (Running costs)
- Gross Profit: $130 (Sales [$300] – COGS [$170])
- Net Profit: $80 (Gross Profit [$130] – Overheads [$50])
A bonus of using the FIFO method is that it follows the order in which companies usually store or stock their product so that the oldest product is the first sold. This is especially good when the product is a consumable with a short shelf life as it then maximizes the value of the product to the customer. Additionally, this method is more likely to protect the company from stocking obsolete items for a significant period of time, as inventory is always on the move’. However, it must be noted that this method also maximizes net profits on paper, and though this sounds beneficial, it can result in a requirement to pay more tax, thereby reducing profits overall. The ending inventory for this method also has a higher associated value which means more insurance is needed in case an adverse event occurs.
Last-In-First-Out or LIFO is the opposite of FIFO and involves the last stocked items to be sold first. The effects of selling like this include a lower gross and net profit due to a higher COGS (the most recent inventory cost the most to buy and therefore costs the most if we sell it). Additionally, the remaining stock value is then lower as this is the older stock which did not cost as much to purchase. Benefits of this system include reporting a lower net profit on paper resulting in less of a tax obligation, however the ending inventory valuation is also lower which contributes to the company’s assets. Another important factor to consider is having older stock remaining, which could result in inventory becoming expired or obsolete thereby jeopardizing the company’s profit margin further should it need replacing.
Average Landed Cost method (ALC) is a far more simple way of doing things where the total cost of the inventory on hand is divided by the total number of units in inventory, deriving an average value for each unit regardless of when it was receipted or how much was paid for it. The net profit on paper is still not as high as the FIFO method, however the company can report a greater profit than with the LIFO method. This is due to the COGS not being quite as costly because the cost of each unit is an average. If the company’s inventory turns over very quickly, then their inventory value will be far more similar to FIFO than LIFO.
It is vitally important to understand the differences between these different inventory valuation methods and how they are best suited to the type of inventory as well as how they will affect the company’s financial statements and tax obligations at the end of the financial year. What might be right for one company may be wrong for another.