Describe Different Inventory Valuation Methods

The allocation of total inventory costs between ‘cost of sales on the income statement and ‘inventory’ on the balance sheet can vary depending on a company’s choice of inventory valuation method (also known as cost formula or cost flow assumption according to IFRS and US GAAP, respectively). In fact, comparing the performance of companies can be quite challenging because differences that exist in the allowable inventory valuation methods can lead to significantly different amounts being assigned to inventory and the cost of sales.

If the choice of valuation method results in more cost being allocated to cost of sales and less cost being allocated to inventory than would be the case with other methods, then the reported gross profit, net income, and inventory carrying amount in the current year will be lower than if an alternative method had been used.

Inventory Valuation Methods

IFRS and US GAAP allow companies the choice of using either of the following inventory valuation methods: specific identification; first-in, first-out (FIFO); and weighted average cost. US GAAP also allows the use of the last-in, first-out (LIFO) method.

Companies must use the same inventory valuation method for all items that are similar in nature and use. A different valuation method is however allowed whenever items have a different nature or use.

When items are sold, the carrying amount of inventory is recognized as an expense according to the cost formula that is used.

Specific Identification

Unlike the FIFO, LIFO, and weighted average cost methods, the specific identification method is used for inventory items that are not interchangeable. Moreover, it is used for goods that have been produced and segregated for specific projects. Finally,  the method is also commonly used for expensive goods, such as gemstones, that are uniquely identifiable.

The method matches the physical flow of the specific items sold, as well as those remaining in the inventory, to their actual costs. The cost of sales and the cost of ending inventory reflect the actual costs that have been incurred in the purchase or manufacture of the items that are specifically identified as sold and those that are specifically identified as remaining in the inventory.

First-in, First-out (FIFO)

This method assumes that the oldest goods to be purchased or manufactured are sold first while the newest goods purchased or manufactured remain in ending inventory.

The cost of sales reflects the cost of goods in beginning inventory plus the cost of items that are purchased or manufactured the earliest in the accounting period. The value of ending inventory reflects the costs of goods purchased or manufactured more recently.

When prices rise, the costs assigned to the units in ending inventory exceed the costs assigned to the units that are sold. Conversely, when prices decline, the costs assigned to the units in ending inventory fall below the costs assigned to the units sold.

Weighted Average Cost

This method assigns the average cost of the goods available for sale during the accounting period to the units that are sold as well as to the units that remain in ending inventory.

In an accounting period,

$$ \text{Weighted average cost per unit}=\cfrac {\text{Total cost of goods available for sale} }{\text{Total units available for sale}} $$

Last-in, First-out (LIFO)

LIFO assumes that the newest goods purchased or manufactured are sold first while the oldest goods purchased or manufactured, including beginning inventory, remain in ending inventory.

The cost of sales reflects the cost of goods purchased or manufactured more recently, while the value of ending inventory reflects the cost of older goods.

When prices rise, the costs assigned to the units in ending inventory fall below the costs assigned to the units sold. Conversely, when prices fall, the costs assigned to the units in ending inventory exceed the costs assigned to the units sold.

Question 1

Under which inventory valuation method are the actual historical costs of specific inventory items matched to their physical flow?

1. FIFO method.
2. LIFO method.
3. Specific identification method.

Solution

The correct answer is C.

The specific identification method matches the actual historical costs of specific inventory items to their physical flow. The FIFO, weighted average cost, and LIFO methods, on the other hand, are based on cost flow assumptions. Under these methods, companies must make assumptions about the goods which are sold and those which remain in ending inventory.

Question 2

Which of the following methods would yield higher net income if the prices of production inputs remain constant?

1. FIFO.
2. LIFO.
3. Neither FIFO nor LIFO.

Solution

The correct answer is C.

The main purpose of every inventory valuation method is to make an assumption about the flow of production cost and to divide that cost between the cost of goods sold and the cost of inventory. If prices of production inputs remain constant, there would be no need to make that assumption. This is due to the fact that the cost of inventory at the beginning of the period would be equal to the cost of products produced or purchased during the period. Hence, no matter which inventory valuation method a company employs, the firm would produce the same net income result.