Inventory costing: FIFO, weighted average, LIFO and lower of cost and net realizable value

When a merchandiser buys identical goods at different prices, it must decide which cost goes to cost of goods sold when one unit is sold and which stays in inventory. That choice does not change how many units were sold or how much cash came in, but it changes reported gross profit, net income, the inventory figure on the balance sheet and, in some countries, income tax. This lesson explains the cost flow methods allowed under the standards, works them through for Birchwood Bikes' city bicycles, compares their effects when prices are rising, explains the lower of cost and net realizable value rule, shows how an inventory error carries through two years, and introduces methods for estimating inventory.

What goes into inventory cost

The cost of inventory includes all costs to bring the goods to their present location and condition: the purchase price net of discounts and returns, freight-in, import duties, and non-recoverable taxes. It excludes storage after the goods are ready for sale, selling costs and abnormal waste, which are expensed. Recoverable taxes, such as GST/HST for a Canadian registrant, are not part of cost. For a manufacturer, cost also includes materials, labor and an allocation of production overhead, a topic for ACCT-102 and ACCT-222.

The cost flow methods

Under US GAAP (ASC 330), inventory costs may be assigned by specific identification, first-in, first-out (FIFO), weighted average cost, or last-in, first-out (LIFO). LIFO is prohibited under IFRS, which most other countries use, but it remains common among US companies with rising costs because of a tax advantage explained below. A company applies its chosen method consistently and discloses it.

Specific identification tracks the actual cost of each unit sold. It suits expensive, distinguishable items such as cars, jewelry, custom bicycles and real estate, and is required for items not ordinarily interchangeable. For large numbers of identical items it is impractical and could be used to manipulate profit by choosing which unit to 'sell'.

FIFO assumes the oldest units are sold first, so cost of goods sold reflects older costs and ending inventory reflects the most recent costs. That matches the physical flow of most goods, especially perishables. Weighted average assigns every unit the average cost of the goods available. Under a periodic system, one average is computed for the whole period. Under a perpetual system, a new moving average is computed after each purchase.

LIFO assumes the newest units are sold first, so cost of goods sold reflects the most recent costs and ending inventory may include very old costs. When prices rise, LIFO gives higher cost of goods sold and lower taxable income. Because the tax code's LIFO conformity rule requires a company using LIFO for tax to use it in its financial statements too, many US companies report on LIFO and disclose the LIFO reserve, the difference between inventory at FIFO and at LIFO. Analysts add back the reserve to compare a LIFO company with a FIFO or IFRS company.

A worked example

Birchwood Bikes sells one model of city bicycle. In July it had the following activity. Under a periodic system, the count at 31 July shows 14 bicycles on hand.

Goods available for sale cost $20,775, and that total must be split between cost of goods sold (36 units) and ending inventory (14 units). Each method splits it differently.

# Periodic FIFO, weighted average and LIFO for July (illustrative)
layers = [(10, 400), (20, 410), (15, 425), (5, 440)]   # oldest first
sold, price = 36, 650
units = sum(u for u, _ in layers)
cost_available = sum(u * c for u, c in layers)

def cost_of(n, ordered):
    total = 0
    for u, c in ordered:
        take = min(u, n)
        total += take * c
        n -= take
        if n == 0:
            break
    return total

fifo_cogs = cost_of(sold, layers)
lifo_cogs = cost_of(sold, list(reversed(layers)))
avg = cost_available / units
avg_cogs = round(avg * sold, 2)

print(f"Goods available {units} units, cost {cost_available:,}")
for name, cogs in (("FIFO", fifo_cogs), ("Weighted average", avg_cogs), ("LIFO (US only)", lifo_cogs)):
    ending = cost_available - cogs
    gp = sold * price - cogs
    print(f"{name:<17} COGS {cogs:>9,.2f}  ending inventory {ending:>8,.2f}  gross profit {gp:>9,.2f}")

Goods available 50 units, cost 20,775
FIFO              COGS 14,750.00  ending inventory 6,025.00  gross profit  8,650.00
Weighted average  COGS 14,958.00  ending inventory 5,817.00  gross profit  8,442.00
LIFO (US only)    COGS 15,135.00  ending inventory 5,640.00  gross profit  8,265.00

FIFO charges the 10 bicycles at $400, all 20 at $410 and 6 of the 15 at $425 to cost of goods sold, a total of $14,750, leaving the newest units ($425 × 9 + $440 × 5 = $6,025) in inventory. Weighted average uses $20,775 ÷ 50 = $415.50 for every unit: cost of goods sold $14,958 and ending inventory $5,817. LIFO charges the newest units first: cost of goods sold $15,135 and ending inventory $5,640. With rising prices, FIFO gives the lowest cost of goods sold and highest profit and inventory, LIFO the reverse, and weighted average falls between. When prices fall, the order flips.

Perpetual FIFO and moving average

Under a perpetual system, costs are assigned at the moment of each sale. FIFO gives exactly the same results under periodic and perpetual systems, because the oldest units are always the first ones out. Weighted average differs: the perpetual moving average is recomputed after each purchase, so sales early in the month use a lower average than sales later. Software handles this automatically, but it is worth working one example by hand.

Lower of cost and net realizable value

Inventory must not be carried above the amount the business expects to get for it. Net realizable value (NRV) is the estimated selling price in the ordinary course of business less the estimated costs of completion and sale. If NRV falls below cost, because goods are damaged, obsolete or selling prices have dropped, inventory is written down to NRV and the loss is recognized in cost of goods sold (or a separate line) in the period of the decline. The write-down is usually done item by item or for groups of similar items.

Under US GAAP, inventory measured by FIFO or average cost uses the lower of cost and NRV. Inventory measured by LIFO or the retail method uses the older lower of cost or market rule. US GAAP does not allow write-downs to be reversed later; IFRS does.

Inventory errors

Because ending inventory of one year is beginning inventory of the next, an error in counting or costing inventory affects two years. If ending inventory is overstated, cost of goods sold is understated and net income is overstated in that year. Next year, beginning inventory is overstated, so cost of goods sold is overstated and net income is understated by the same amount. Over the two years combined, total net income is correct, and by the end of the second year retained earnings is correct, but each year's results are wrong. That self-correcting pattern does not excuse the error: users compare years, and lenders may lend on the strength of an overstated year.

Estimating inventory

Businesses sometimes need an inventory figure without counting: for monthly statements, after a fire or theft for an insurance claim, or to test whether a count is reasonable. The gross profit method estimates cost of goods sold from sales and the normal gross margin. The retail method, used by department stores, keeps records at both cost and retail prices and applies the cost-to-retail ratio to ending inventory at retail.

Inventory turnover, cost of goods sold divided by average inventory, and its companion, days' sales in inventory, show how quickly stock sells. Lesson 12 uses them. The choice of cost flow method affects these ratios, so analysts check which method a company uses before comparing it with another.