Inventory Valuation Methods

There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold.

Inventory method
How it works
When used
Specific Identification the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory auto sales, gems and jewelry, works of art, unique, one of a kind items
First In, First Out (FIFO) cost of earliest purchases flow to COGS; we assume that the items remaining at the end are the last ones bought in the year eggs, milk, meat, produce; this is the defaultflow assumption, unless a different method is specified
Last In, First Out (LIFO) cost of last purchases flow to COGS; we assume that the items remaining at the end are the earliest ones bought in the year clothing, seasonal items; a highly specialized method of retail inventory
Average Cost cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used lumber, nails, nuts and bolts (simple average);  gasoline (moving average)

Using a Cost Flow Assumption

  • must meet cost-benefit rule
  • accounts for quantities of homogeneous products
  • matches the physical flow of goods
  • can be used with either Periodic or Perpetual costing system
Specific Identification

The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper?

Most business would answer “No” to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.

For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.

FIFO: First In, First Out

In the First In, First Out (FIFO)method we assume that the earliest merchandise bought is also sold first. For instance, a grocery store will buy only the amount of milk it can sell in a week. Because milk spoils quickly, the store will buy small amounts each week, and make sure the milk it has for sale is the freshest milk available.

Further, one gallon of milk is basically the same as the next gallon (with only minor differences). We say that milk is a homogeneous product. All the milk can be viewed as a single product group, that follows an almost identical weekly sales and spoilage pattern.

The grocery will use a flow assumption to value its milk inventory at the end of the year. They will use FIFO, assuming that the milk on hand is the last milk that was bought during the year.

The LIFO method would assume that the milk bought in the first week of the year is the same milk on the shelf at the end of the year. Obviously year old milk will probably be coagulated into a solid, stinking block of green muck. So we know that LIFO would be an incorrect flow assumption for milk. So when will the LIFO assumption will be valid?

LIFO: Last In, First Out

The Last In, First Out (LIFO) method assumes the most  purchased merchandise will also be the first sold. Let’s now picture a clothing store. There are basically 4 clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing for each season. Further, clothing styles change each year. Except for a few items (socks, handkerchiefs, belts) customers will prefer to buy this year’s fashions, rather than last year’s fashions. Here’s how that works into the LIFO method.

At the end of the year the clothing store looks at its merchandise. If their year ends in December, they have Winter clothes in the show room. But when they look in the storage room, most of the clothes there are from earlier seasons that year. So Last In, First Out means, the most current seasons clothes (Last In) are the ones that people want now (First Out). After all, you wouldn’t be buying last summer’s clothes in the middle of winter, would you? Most people will wait until the following year and buy clothes in style in the coming summer.

Average Cost

Some merchandise is nearly identical and is carried in large quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank on gasoline with say 50 gallons in it, and you add 200 more gallons, you can’t separate the first 50 gallons out from the rest of it. It all just becomes on take with 250 gallons of gasoline in it. So companies use the average cost method to account for things like this.

If you run a gas station, your costs will change every week. You will always have some left in the tank from the week before, and the delivery truck will dump more gas in your tank at this week’s prices. Gas stations use a moving average method – they take the moving average from last week, and calculate a new moving average after adding this weeks batch of gasoline to the tank. So a moving average updates the cost frequently, and applies that particular average cost to that week’s gasoline sales. Next week they will calculate a new moving average and apply it to next week’s gasoline sales, etc.