Inventory Methods
| The main inventory methods that businesses use to report inventory cost (cost of goods sold) and inventory reporting on the balance sheet are listed below. |
Four Main Inventory Methods:
Cost Flow Assumptions:
|
Inventory Reporting and Average Cost
Average cost is the simplest of the four main inventory methods. Under this method the amount of goods made available for sale (beginning inventory + net purchases) is divided by the number of units available for sale to determine the average price. The average price is then applied to items sold and items in inventory to determine the amount of cost of goods sold and ending inventory.
Average Cost Allowed for Financial Inventory Reporting Only, not Inventory Tax Reporting
| The average cost method is allowed for financial reporting purposes but is not allowed for income tax reporting purposes (Rev. Ruling 71-234). |
In our example, Sunny calculates average cost as:
Average Cost
| $3,360 | 240 Sunglasses @$14 each: |
| $3,600 | 240 Sunglasses @$15 each: |
| $3,840 | 240 Sunglasses @$16 each: |
| $10,800 Total | 720 Total Sunglasses |
| Average Price = 10,800/720 = $15 | |
From the average cost of $15 per pair, Sunny would calculate cost of goods sold and ending inventory. Since Sunny had a total of 720 Sunglasses on hand assuming no beginning inventory, and had sold 25 pairs of sunglasses this particular day, Sunny calculates ending inventory and the inventory cost as follows:
Inventory Costing Using Average Cost
Inventory Cost: |
||
| 25 @ $15: | ||
| $375 | ||
| Total cost of goods sold: $375 | ||
Inventory Reporting Using Average Cost
Inventory Reporting |
||
| 695 @ $15: | ||
| $10,425 | ||
| Total Ending Inventory: $10,425 | ||
Inventory Methods Compared
Inventory Cost
| Last in First Out(LIFO) | Average Cost | Specific Identification | First in First Out (FIFO) |
| $400 | $375 | 366 | 350 |
Inventory Reporting
| First in First Out (FIFO) | Specific Identification | Average Cost | Last in First Out(LIFO) |
| $10,450 | $10,434 | 10,425 | 10,400 |
In this example, the inventory cost (cost of goods sold) for one day ranges from $350 using FIFO to $400 using LIFO, a 14% change simply by changing an accounting method. Inventory reporting (ending inventory) ranged from $10,400 to $10,450 for one day.
In 2010, Sunny sold 2,880 pairs of sunglasses. Sunny purchased the sunglasses with the following purchase orders during the year:
Actual Physical Flow of Inventory 2010
| Purchase Order 1: | Purchase Order 2: | Purchase Order 3 |
| 1085 Sunglasses @$14 each: | 1085 Sunglasses @$15 each: | 1085 Sunglasses @$16 each: |
| $15,190 | – | – |
| – | $16,275 | – |
| – | – | $17,360 |
Inventory Cost Under Each of the Inventory Methods
| Last in First Out(LIFO) | Average Cost | First in First Out (FIFO) |
| $43,575 | $43,200 | $42,825 |
Of the three inventory methods, LIFO and FIFO will produce the most extreme results, and average method will usually fall somewhere in between. By simply choosing a different accounting method, the inventory cost can range from $42,825 to 43,575, a 2% difference.
Inventory Reporting Under Each of the Inventory Methods
| First in First Out (FIFO) | Average Cost | Last in First Out(LIFO) |
| $6,000 | $5,625 | $5,250 |
Similarly, by choosing a different inventory method, inventory reporting can vary from $5,250 to $6,000, a 14% difference!
Inventory Methods and Goods Available for Sale
The total good available for sale (Beginning Inventory + Net Purchases) remains the same under each of the inventory methods: $48,825. The difference lies in where the costs are shifted.
FIFO shifts the higher costs to ending inventory during periods of rising prices, while LIFO shifts the higher costs to cost of goods sold during the same period. The average cost method generally settles somewhere in between the two other inventory methods. During periods of deflation, the reverse is true.
Actual Inventory Methods, Inventory Costing, and Inventory Reporting in 2008
| Company | Inventory Methods | Inventory Cost (COGS) | Inventory Reporting
(Ending Inventory) |
| Wal-Mart | LIFO | 306 billion | 34.5 billion |
| Costco | LIFO | 63.5 billion | 5 billion |
| Home Depot | FIFO | 47.2 billion | 10.6 billion |
| Sunglasses Hut Int.(Luxottica Group) | Weighted Average | 2.4 billion | 794 million |
In periods of rising prices, LIFO better matches actual inventory cost (cost of goods sold) with revenue, and provides a significant tax break. For example, Costco lowered its gross profit by $32.3 million per its annual disclosure for inventory valuation in 2008:
Costco’s Inventory Valuation Disclosure for 2008 Annual Report
| Merchandise inventories are valued at the lower of cost or market, as determined primarily by the retail inventory method of accounting, and are stated using the last-in, first-out (LIFO) method for substantially all U.S. merchandise inventories.
We believe the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. The LIFO inventory adjustment in 2008 reduced ending inventory and gross margin by $32.3 million. |
This is a potential tax savings of $11.3 million considering a typical 35% tax rate!
Depending on what the goal for a business is, whether lower taxes, higher profits, or ending inventory asset valuation, each of the four main inventory methods can significantly impact net income, taxes, and the balance sheet.
This is especially true for lowering taxes for the period, a primary goal of many businesses. Considering many businesses sell and hold millions of dollars of inventory, and a typical corporate income tax rate is 35%, the tax savings can be substantial simply by selecting one of the inventory methods for inventory costing and inventory reporting.
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