Choosing the right inventory valuation method for your inventory isn’t as easy as you think. Before you make a thorough analysis, take a look at three of the most common methods used in businesses:
Specific Identification and Average Cost
The specific identification and average cost methods represent two basic methods for valuing and costing inventory. The specific identification method requires businesses to identify the cost of each item by recording the purchases according to the actual price paid for each inventory item. Companies with limited and unique products commonly use the specific identification method. The average cost method takes the average cost of all items held in inventory and values them according to the average price paid across all inventory items. Source: SmallBusiness.Chron
First-in, First-out (FIFO)
According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most widely used method for inventory valuation. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced. Source: AccountingExplained
Last-in, Last-out (LIFO)
“Last in, Last out,” or LIFO, uses the opposite assumptions of FIFO. Under LIFO, the inventory you most recently purchased is considered to be the first sold. It can be appropriate for inventory that doesn’t tend to go bad, like metals or other raw materials. The problem is, because the oldest inventory may be never officially “sold,” LIFO can create layers of old inventory. This makes converting to another inventory method later a time-consuming, accounting headache.
Many companies find the financial benefits of LIFO outweigh the problems. In times of rising prices, LIFO creates a lower gross profit and reduces income tax liability. It’s nice to see a higher accounting profit, but most business owners prefer to have more cash in the bank. Source: Quickbooks.Intuit
If you’re looking for help in choosing which method is the right one for you, one of our well experienced accountants can help! Call us today!
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