Evaluating stock levels is a crucial aspect of the accounting and financial reporting procedures within businesses. The chosen method can greatly affect the assessment of stocks, tax consequences, and financial outcomes revealed.
This blog will outline the three weighted average method utilised to evaluate inventory: Weighted Average Cost, First-In, First-Out (FIFO), and Last-In, First-Out (LIFO). We will examine the differences, advantages, and disadvantages, and provide examples for better understanding.
Weighted Average Method
The Weighted Average Method computes the expenses of all units in stock during a specific timeframe to determine the final inventory and cost of goods sold (COGS). This method provides a thorough approach to determining inventory worth by reducing price changes during the accounting timeframe.
Weighted Average Method Formula
The formula for the Weighted Average Method is simple.
The weighted average cost is equal to the total cost of goods available for sale divided by the total units available for sale.
This formula ensures that the mean expense of each stock item remains consistent, regardless of when it was bought.
The advantages and disadvantages of the weighted average method
Benefits
- The Weighted Average Method simplifies inventory management and cost computations.
- When deciding on prices and profitability, it offers a more consistent cost per unit, which is helpful.
- A steady inventory value is ensured by consistency, which prevents large cost swings.
Cons
- Less accurate: In sectors with rapid inventory turnover, it may not accurately represent the real flow of goods.
- Tax Implications: This technique may raise taxable income during inflationary times compared to LIFO.
Example of the Weighted Average Method
Imagine a business that purchases the following goods over a given time period:
- Using the Weighted Average Method formula, 100 units at $10 each and 200 units at $15 each were calculated.
- Cost of Weighted Average = (100 × 10) + (200 × 15)
1000 +2000/3000.
4000/300 = $13.33
The ending inventory and the cost of products sold will be valued using the average cost per unit, which comes out to be $13.33.
The Method of First In, First Out
According to FIFO, the oldest inventory is considered the first to be sold. This technique works especially well for companies that handle perishable items or outdated inventory.
FIFO’s Benefits and Drawbacks
Benefits
- Pragmatic Flow: Since FIFO typically tracks the true flow of goods, it is more logical and realistic.
- Enhanced Earnings: FIFO may lead to decreased costs for sold goods and increased earnings during inflationary times.
Drawbacks
- Increased Taxes: As a result of FIFO’s higher profits, tax responsibilities could increase.
- Inventory Valuation: Inflationary times may cause unsold stock to be valued at outdated, lower prices, undervaluing the stock.
The Method of Last In, First Out Method
Using the LIFO technique, the last-purchased items are taken to be the first-sold items. This tactic is advantageous in sectors where inventory costs are rising since it can lower tax obligations by raising the amount spent on items sold.
Benefits and Drawbacks of LIFO
Advantages
- Tax benefits: In an environment where prices are rising, LIFO may result in lower taxable income.
- Better Matching: It provides a more accurate picture of profitability by matching current costs with current revenues.
Drawbacks
- Complication: LIFO requires careful record-keeping and may be more difficult to manage.
- LIFO’s use is limited in many nations since it is not recognized globally for tax purposes.
FIFO and LIFO Examples
FIFO Example
Think about a business that sells electronic products only. Here’s a fundamental scenario:
- January 1st: Purchase 100 things at $10 apiece.
- February 1st: Purchase 200 pieces at $12 apiece.
- March 1st: Purchase 150 things at $15 apiece.
250 units were sold by the business on March 15. The oldest inventory would be used to sell the first 250 units under the FIFO technique.
Calculate
At first, 100 items were bought on January 1st for $10 each.
One million dollars is equivalent to ten multiplied by one hundred.
The product of ten and one hundred is equivalent to one thousand.
Next, adding up the total cost of purchasing 150 items at the price of $12 each on February 1st equals $1,800, which can be found by dividing $1,800 by 150.
According to the FIFO method, the cost of goods sold (COGS) would be the sum of $1,000 and $1,800, resulting in a total of $2,800.
$2,000 (consisting of $1,800 and $1,000)
The remaining items in stock would be:
- 50 pieces starting on February 1 at $12 each.
- 150 pieces at $15 each, available from March 1.
LIFO Example
1. COGS for 400 units:
- 300 units @ $11 = $3300
- 100 units @ $12 = $1200
- Total COGS = $3300 + $1200 = $4500
2. Ending inventory:
- 100 units @ $10 = $1000
- 100 units @ $12 = $1200
- Total ending inventory = $1000 + $1200 = $2200
Comparison of FIFO and LIFO
- FIFO COGS: $2,800
- LIFO COGS: $2200
In this instance, LIFO raises the cost of items delivered, which lowers the taxable income of the business as prices increase. Contrarily, FIFO leads to a lower cost of goods sold, which raises taxable profits for the business and more closely matches the flow of actual inventory.
Comparing the Methods, FIFO, and LIFO Weighted Average Technique:
Costing inventory: Price fluctuations are evened out by the Weighted Average Method, whereas the oldest costs are represented in FIFO and the most recent in LIFO.
Tax consequences: During times of inflation, using the last-in, first-out (LIFO) method generally reduces tax liabilities, while the first-in, first-out (FIFO) method usually increases taxes. The Weighted Average Method is located at the midpoint.
Financial Reporting: FIFO may lead to increased profit during inflation, while LIFO offers a more cautious profit assessment.
FAQs Weighted Average Method: Cost Vs FIFO Vs LIFO
What distinguishing features of FIFO and LIFO are there?
Notable variations include:
- LIFO results in higher Cost of Goods Sold compared to FIFO when prices are rising.
- Inventory Valuation: When inflation happens, FIFO leads to higher ending inventory valuations.
- Tax Implications: FIFO frequently means greater taxes, even if LIFO may result in less taxable revenue.
What impact do approaches for inventory value have on financial reporting?
Inventory valuation methods affect financial reporting by affecting the cost of goods sold, net income, and tax liabilities. The Weighted Average Method provides value stability, while FIFO usually generates higher net income during inflation. LIFO, on the other hand, offers a cautious estimate of profitability.
Which approach to inventory valuation works best for my company?
The kind of your firm, the kind of inventory, and the state of the economy will all influence which course of action is best. The industries whose items are interchangeable benefit from the weighted average method; high turnover and perishable goods are best served by FIFO; and inflation-related tax liabilities are best served by LIFO.
Conclusion
The needs of the business and the state of the economy determine the best method for inventory valuation. While FIFO is better for high turnover and perishable commodities and offers tax benefits during inflation, LIFO might be harder to grasp and is not as popular.
The Weighted Average Method offers stability for related commodities. Companies can more effectively coordinate their financial plan if they are aware of the ramifications of each method. In case you’re looking for more explanations related to the supply chain industry, maybe browse through Qodenext’s website and blogs!
