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FIFO: First In, First Out
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LIFO: Last In, First Out
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Weighted Average
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Here’s what else to consider
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If you run a business that sells physical goods, you need to keep track of your inventory and how much it costs. Inventory valuation is the process of assigning a monetary value to your unsold stock at the end of an accounting period. This affects your income statement, balance sheet, and cash flow. But how do you choose the best method to value your inventory? In this article, we'll explain the pros and cons of using FIFO, LIFO, or weighted average for inventory valuation.
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1 FIFO: First In, First Out
FIFO stands for first in, first out. This means that you assume that the first items you bought or produced are the first ones you sold. For example, if you bought 10 shirts for $10 each in January and 10 more for $12 each in February, and then sold 15 shirts in March, you would calculate your cost of goods sold (COGS) as $10 x 10 + $12 x 5 = $160. Your ending inventory would be $12 x 5 = $60. FIFO is the most common method used by retailers and manufacturers. It reflects the actual flow of goods and matches the current market prices. However, it also inflates your net income and taxes when prices are rising, and it ignores the effects of obsolescence or spoilage.
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2 LIFO: Last In, First Out
LIFO stands for last in, first out. This means that you assume that the last items you bought or produced are the first ones you sold. For example, using the same scenario as above, you would calculate your COGS as $12 x 10 + $10 x 5 = $170. Your ending inventory would be $10 x 5 = $50. LIFO is the opposite of FIFO. It reduces your net income and taxes when prices are rising, and it matches the current cost of replacing your inventory. However, it also distorts your inventory value and creates a mismatch between the market prices and the reported prices. LIFO is not allowed under international accounting standards and some countries' tax laws.
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3 Weighted Average
Weighted average is a method that uses the average cost of all the items in your inventory, regardless of when they were bought or produced. For example, using the same scenario as above, you would calculate your average cost per shirt as ($10 x 10 + $12 x 10) / 20 = $11. Your COGS would be $11 x 15 = $165. Your ending inventory would be $11 x 5 = $55. Weighted average is a simple and consistent method that smooths out the fluctuations in prices and avoids the extremes of FIFO and LIFO. However, it also ignores the actual flow of goods and may not reflect the true profitability or cash flow of your business.
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4 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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