By Andrew W Werner
Companies that have some form of inventory need an inventory costing system. Throughout the years, many ways to calculate inventory costing were developed. However, only four stand out as the most commonly used forms of inventory costing; First-In First-Out (FIFO), Last-In First-Out (LIFO), weighted average, and specific identification. Each way has its own specific mathematical approach to calculating inventory and cost of goods sold, which result in maximizing the company's profit.
The first way, FIFO, is a relatively simple solution. As products are taken from inventory, whichever product was created first will be the calculated cost of goods sold. For example, lets state there was a beginning balance of ten bikes worth ninety dollars a piece for a company. A purchase of ten bikes was made, but each bike was worth one hundred dollars a piece. When a sale is made, the ten bikes worth ninety dollars would be sold first and additional orders would take from the next earliest inventory. Most companies tend to use this method over the other two, because it has the best ending gross profit.
The second way, LIFO, is another relatively simple solution. While FIFO used an ordered way of calculating cost of goods sold, LIFO uses a reverse order. The most recent purchase of inventory goods is sold first, while the products created first will be the last to sell. So going back to the example, the ten bikes worth one hundred dollars a piece would be sold first, while the ten bikes worth ninety dollars a piece will remain in inventory. Unlike FIFO which is primarily used for maximizing profit, LIFO is primarily used to lower taxes for a company. During the 1980's when inflation was rather significant, LIFO was used by many companies to not get taxed on the inflation rate.
Here is where things get a little more complicated. The third method, weighted average, is calculated in such a way that the average of all products in inventory is what the cost of goods sold is. When inventory is sold, the average is recalculated for the next round of sales. For example, lets say ten bikes were worth ninety dollars each and a purchase of ten more bikes worth one hundred dollars each was made. The groups of products are added together and divided by the number of units. When a sale is made, products are sold at that averaged price per unit, which happens to be ninety-five dollars per unit. Lets say for argument's sake that fifteen units are sold, leaving five units left. After the sale, the inventory balance remaining is added together and divided by the total number of units left. Another purchase is made of ten units worth eighty dollars a piece. The cycle of averaging the price per units continues.
The fourth and last method, specific identification, is used to assign costs to each specific unit. A great example of when this is actually used is in the car market. When a sale is made, the sold units of product are taken from every different group of inventory. For example, lets say there is ten bikes at ninety dollars a piece and ten bikes at one hundred dollars a piece. Inventory is written where ten bikes are worth ninety dollars each and ten bikes are worth one hundred dollars each. When a sale of ten units is made, five units worth ninety dollars a piece are sold, and five units worth one hundred dollars a piece are sold. Inventory is recalculated and the balance of each group is five bikes worth ninety dollars a piece and five bikes worth one hundred dollars a piece.
Although there are many methods that are used to calculate an inventory costing system, only four really stand out. First-in first out, last-in first out, weighted average, and specific identification. First-in first out is used primarily to maximize gross profit in a company, while last-in first out is used to primarily reduce taxes. The weighted average method is the average of all unit costs divided by number of units, and is primarily used to keep a standard price per unit. Lastly, the specific identification method is used to identify specific units of product and calculate the inventory costing as an individual item. This method is commonly used while selling in the car market. No matter what method a company ends up choosing to use for their inventory costing system, it is important to remain with that system throughout all calculations.
The first way, FIFO, is a relatively simple solution. As products are taken from inventory, whichever product was created first will be the calculated cost of goods sold. For example, lets state there was a beginning balance of ten bikes worth ninety dollars a piece for a company. A purchase of ten bikes was made, but each bike was worth one hundred dollars a piece. When a sale is made, the ten bikes worth ninety dollars would be sold first and additional orders would take from the next earliest inventory. Most companies tend to use this method over the other two, because it has the best ending gross profit.
The second way, LIFO, is another relatively simple solution. While FIFO used an ordered way of calculating cost of goods sold, LIFO uses a reverse order. The most recent purchase of inventory goods is sold first, while the products created first will be the last to sell. So going back to the example, the ten bikes worth one hundred dollars a piece would be sold first, while the ten bikes worth ninety dollars a piece will remain in inventory. Unlike FIFO which is primarily used for maximizing profit, LIFO is primarily used to lower taxes for a company. During the 1980's when inflation was rather significant, LIFO was used by many companies to not get taxed on the inflation rate.
Here is where things get a little more complicated. The third method, weighted average, is calculated in such a way that the average of all products in inventory is what the cost of goods sold is. When inventory is sold, the average is recalculated for the next round of sales. For example, lets say ten bikes were worth ninety dollars each and a purchase of ten more bikes worth one hundred dollars each was made. The groups of products are added together and divided by the number of units. When a sale is made, products are sold at that averaged price per unit, which happens to be ninety-five dollars per unit. Lets say for argument's sake that fifteen units are sold, leaving five units left. After the sale, the inventory balance remaining is added together and divided by the total number of units left. Another purchase is made of ten units worth eighty dollars a piece. The cycle of averaging the price per units continues.
The fourth and last method, specific identification, is used to assign costs to each specific unit. A great example of when this is actually used is in the car market. When a sale is made, the sold units of product are taken from every different group of inventory. For example, lets say there is ten bikes at ninety dollars a piece and ten bikes at one hundred dollars a piece. Inventory is written where ten bikes are worth ninety dollars each and ten bikes are worth one hundred dollars each. When a sale of ten units is made, five units worth ninety dollars a piece are sold, and five units worth one hundred dollars a piece are sold. Inventory is recalculated and the balance of each group is five bikes worth ninety dollars a piece and five bikes worth one hundred dollars a piece.
Although there are many methods that are used to calculate an inventory costing system, only four really stand out. First-in first out, last-in first out, weighted average, and specific identification. First-in first out is used primarily to maximize gross profit in a company, while last-in first out is used to primarily reduce taxes. The weighted average method is the average of all unit costs divided by number of units, and is primarily used to keep a standard price per unit. Lastly, the specific identification method is used to identify specific units of product and calculate the inventory costing as an individual item. This method is commonly used while selling in the car market. No matter what method a company ends up choosing to use for their inventory costing system, it is important to remain with that system throughout all calculations.
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