Inventory is an important factor in the evaluation of any businesses' finances. There are four generally accepted accounting principles, or GAAP, inventory accounting methods that can be used to manage inventory. The method chosen has a direct impact on the financials based on how the costs of the inventory flow into the cost of goods sold account. The cost of goods sold is the cost of products sold as it comes out of inventory. All costs that go into making a product are included.
The first method is the weighted average inventory management and valuation method. This method is easier to use with large numbers of identical items. The weighted average is calculated by averaging the costs of an item available for sale over the product population. To arrive at the correct answer you calculate the cost of the beginning inventory plus any purchases of that item for the month, quarter or year. Then add the total cost together and divide by the amount of purchases made for the same period of a month, quarter or year. For example, if a motorcycle dealer purchased 100 new helmets at the cost of $60 per helmet, and a month later purchased 100 more helmets at $50 each, then the weighted average would be $55 each or $11,000.
First-in, First-out, FIFO, Method
First-in, first-out, FIFO, is another method often chosen by many companies. FIFO means that the first items which are purchased are also the first items sold; in other words, the oldest inventory is sold first. Grocery stores practice this type of inventory method often because many of their products are perishable. Using this method, the cost of that item is incurred whenever that item is sold. In many circumstances older inventory is cheaper than newer inventory based on rising costs. Based on this assumption, the sales price will also increase. A larger net profit can be booked when older inventory is sold. However, this also has tax consequences that raises the tax bill in the negative direction.
Last-in, First-out, LIFO, Method
Last-in, first-out, LIFO, is the last method. Using this method, the newest inventory is recoded as being sold first. This happen often in stores with non-perishable goods. Older items are pushed to the back of the display while newer ones are placed in the front. Therefore, new items are the first out. This method will conclude that more expensive inventory has been sold and will decrease the net income but will also lower the tax burden.
Specific identification is the last method of inventory management and inventory valuation. This method ties a specific item to the sale instead of looking at the inventory stockpile as a whole. In this method, when a specific item is sold, the cost of that specific item is identified and is carried through to the cost of goods sold account and recorded. This is in place of averaging the cost of sales over a month and grouping them into categories. This method is very time consuming and requires a great deal of labor and record keeping. It is expensive and is used in circumstances when the items being sold are very expensive, like a bulldozer. These items can be tracked by their serial or vehicle identification numbers.