Calculating Inventory Value

A company can raise or lower its earnings by changing the way it calculates the cost of goods sold. As inventory items are purchased during the accounting period, their unit cost may vary. A costing method is a way of calculating the cost of goods sold. The first time you purchase a product, the value is whatever you paid. Once you receive more stock at a different price, it is necessary to use one of the three standard methods to determine the value of what you sell. The three most popular methods used to determine the value of the ending inventory are:

ü First in, First out (FIFO)

ü Last in, First out (LIFO)

ü Average cost

Important Note: You should consult your accountant regarding the method that best suits your needs.

First in, First out (FIFO)

This method assumes that the first item to come into the inventory are the first items sold, so the most recent unit cost is used to determine the inventory’s value. FIFO assumes that the oldest stock you have is sold first. At a time when your cost is constantly increasing, the first items sold are the least expensive ones, therefore your cost of goods sold is low and your income is greater.

Last in, First out (LIFO)

This method assumes that the last item to come into the inventory are the first items sold, so the oldest unit cost is used to determine the inventory’s value. With LIFO, the newest stock is sold first. An inventory value should generally reflect the replacement cost of your stock and that is what LIFO does. When prices are increasing LIFO will calculate cost of goods sold at the most recent price, resulting in a higher cost of goods and lower income.

Average Cost

This method uses the average unit cost for all items that were available for sale during the accounting period. The Average method is the total cost of all goods divided by the number in stock. This has the effect of leveling out price fluctuations, providing a constant cost of goods and income.

Let us discuss an example that will clarify this concept. For example, suppose you sell Boxes. On August 1, you purchase 100 Boxes for $1.00 each for a total cost of $100. On August 2, you purchase another 100 Boxes, this time at $1.25 per box for a total cost of $125. You now have purchased 200 Boxes for $225.

On August 3, you sell 50 Boxes for $1.50 each for a total of $75. Depending which costing method you are using, your income will be different:

FIFO: This method would assume the 50 boxes you sold were from the first 100 boxes you bought (at $1 each). Your cost of goods would be $50 and your profit would be $25.

LIFO: It is assumed that the 50 boxes sold were from the last 100 boxes you purchased (at $1.25 each). Your cost of goods is then $62.50 for a profit of $12.50.

Average: This method will consider only that you bought 200 boxes for $225, for an average cost of $1.125 each. Your cost for the 50 boxes sold is $56.25 and you will have a profit of $18.75.

When the income statement is prepared, the cost of inventory on hand is subtracted from the Cost of Goods Available for Sale during the year. This yields the Cost of Goods Sold for the year. You should check with your accountant to determine which method suits your needs.