Historic Cost BASeD Methods-II
Last In First Out (LIFO)
In this method of inventory valuation, Items purchased at last are assumed to be issued first. On the contrary to FIFO, if the most recent lot purchased has been completely consumed, issued only then the items from the older lot are assumed to be issued/ consumed.
For Example a stationary seller made following transactions during the Month of August-2X20:
| Date | Description | Value | Balance |
| 01 August 2X20 | Purchase 05 Notebooks @ $2 each | $10 | $10 |
| 05 August 2X20 | Sold 02 Notebooks | ($4) | $6 |
| 06 August 2X20 | Purchase 10 Notebooks @ $3 each | $30 | $36 |
| 08 August 2X20 | Sold 08 Notebooks (Balance 05 Notebooks) All 08 Note from fresh stock purchased on 06 August @$3 each | ($24) | $12 |
From the above illustration, it can be seen how value is assigned to the issuing stock while using the LIFO method of valuing Inventory.
For each issuance/consumption, first rate from the inventory items from the latest available lot are assigned and if the items from the latest lot have been finished, only then the rates of items from the older lot are assigned to remaining items being issued.
Consider the item sold on 08th August 2X20. At this date we had a total of 13 notebooks, 03 notebooks from the oldest lot (purchased at 01st August), whereas 10 from the fresh lot (purchased at 06th August).
While assigning the value to notebooks being sold, it was assumed that first notebooks from the latest stock will be sold, so we assigned the rate of $3 to all 8 notebooks (8 @$3=$24).
Further, the remaining 3 out of 5 notebooks are from the lot purchased on 1st August, and 2 out of the remaining 5 notebooks are from the lot purchased on 6th August. Therefore, stock at the 8th August being valued at $12 (3 @ $ 2 each plus 2 @$3).As in the LIFO method of valuation, the most recent purchases are assumed to be issued first, therefore the rates assigned to the issuance/ consumption reflect the most recent market price. In the above stated example, it can be noticed that both the time when notebooks were sold (i.e. 05th and 8th August), the most recent prices were assigned to Notebooks sold.
Advantages of using lifo
In LIFO, the inventory items being issued are assigned the rates from the latest purchases, hence COGS reflects the most recent cost of the items.
· In the LIFO method historic costs are assigned for valuing Inventory, therefore unrealistic profits cannot be recorded.
Disadvantages of using LIFO
· In LIFO method of valuing inventory, inventory purchased at the end is assumed to be consumed earlier, therefore the closing stock usually shall be from the oldest lot purchased. Therefore, the closing inventory will reflect the cost of oldest purchases and the current market price.
· Further, in case of fluctuating raw material prices, LIFO makes it difficult to compare prices of similar finished goods over time.
Average Costing (AVCO)
In this method an average cost is assigned to each item of inventory. After purchase of every new lot of inventory, an average cost per unit is calculated by adding the total cost of old and new inventory and then devising it by total available units of Inventory.
For Example a stationary seller purchased made following purchases during the Month of August-2X20:
| Date | Description | Value | Balance |
| 01 August 2X20 | Purchase 05 Notebooks @ $2 each | $10 | $10 |
| 05 August 2X20 | Sold 02 Notebooks | ($4) | $6 |
| 06 August 2X20 | Purchase 10 Notebooks @ $3 each | $30 | $36 |
| 08 August 2X20 | Sold 08 Notebooks (Balance 05 Notebooks)All 08 units sold and 05 unit in closing stock are assigned an average cost of $2.77/unit | ($22.16) | $13.84 |
From the above illustration, it can be seen how value is assigned to the issuing stock while using the AVCO method of valuing Inventory.
After every new purchase of the inventory stock, an average cost per unit is recalculated by adding the value of new stock and old stock and then dividing this by total number available stock. Thus, we had $2.77 average cost per unit after incorporating the purchases made on 6th August.
While assigning the value to the sales made and eventual closing stock on 8th August, the average cost of $2.77 was assigned to each of the inventory item (e.g. for COGS 8X$2.77= $22.16 and for closing stock 5X $ 2.77= $13.85)
This method is easy to calculate and saves from the complex calculation of FIFO and LIFO. Further, as the costs of every purchased lot is averaged out, the effect of price fluctuation is neutralized.
A comparison of effects of using different valuation methods of Inventory
FIFO, LIFO and AVCO are the most common methods in practice for valuing inventories. The different valuation methods result in different values being assigned to COSG and Closing stock.
The below statement will provide us a comparison on how these famous methods will produce different results for valuation of COGS and closing stock at the period end.
Valuation using FIFO Method:
| Activity | Balance | ||||||
| Date | Description | Units | Rate | Amount | Units | Rate | Amount |
| 01 August 2X20 | Purchase 05 Notebooks @ $2 each | 5 | $2.00 | $10.00 | 5 | $2.00 | $10.00 |
| 08 August 2X20 | Sold 02 Notebooks | -2 | $2.00 | ($4.00) | 3 | $2.00 | $6.00 |
| 15 August 2X20 | Purchase 10 Notebooks @ $3 each | 10 | $3.00 | $30.00 | 13 | 3 units @ $ 2 10 units @ $ 3 | $36.00 |
| 31 August 2X20 | Sold 08 Notebooks | -8 | 3 units @ $ 2 5 units @ $ 3 | ($21.00) | 5 | 5 units @ $ 3 | $15.00 |
Valuation using LIFO Method:
| Activity | Balance | ||||||
| Date | Description | Units | Rate | Amount | Units | Rate | Amount |
| 01 August 2X20 | Purchase 05 Notebooks @ $2 each | 5 | $2.00 | $10.00 | 5 | $2.00 | $10.00 |
| 08 August 2X20 | Sold 02 Notebooks | -2 | $2.00 | ($4.00) | 3 | $2.00 | $6.00 |
| 15 August 2X20 | Purchase 10 Notebooks @ $3 each | 10 | $3.00 | $30.00 | 13 | 3 units @ $ 210 units @ $ 3 | $36.00 |
Valuation using AVCO Method:
| Activity | Balance | ||||||
| Date | Description | Units | Rate | Amount | Units | Rate | Amount |
| 01 August 2X20 | Purchase 05 Notebooks @ $2 each | 5 | $2.00 | $10.00 | 5 | $2.00 | $10.00 |
| 08 August 2X20 | Sold 02 Notebooks | -2 | $2.00 | ($4.00) | 3 | $2.00 | $6.00 |
| 15 August 2X20 | Purchase 10 Notebooks @ $3 each | 10 | $3.00 | $30.00 | 13 | $2.77 | $36.00 |
| 31 August 2X20 | Sold 08 Notebooks | -8 | $2.77 | ($22.15) | 5 | $2.77 | $13.85 |
From the above given 3 tables we can extract the following comparative statement for the month of August, 2X20;
| FIFO | AVCO | LIFO | |
| COGS (Sales on 08th and 31st August) | $25.00 | $26.15 | $28.00 |
| Closing Stock as on 31st August | $15.00 | $13.85 | $12.00 |
From the above comparative statement it can be seen that during the times when prices were increasing, the FIFO method of valuing inventory provided lowest COGS and highest value of Closing stock on 31st August, 2X20. This happened because while issuing the inventories for sale, the cost of lower purchases (oldest) were considered, however, the closing stock of all 5 units includes the purchases of expensive (fresh) lots.
Whereas the LIFO provided the highest COGS and the lowest value of closing stock on the month end date. This happened because while issuing the inventories for sale, the cost of higher purchases (fresh) were considered, however, the closing stock of 3 units includes the purchases of cheaper (oldest) lot.
However, the use of AVCO method neutralized the effect of rising prices among older and fresh stock.
Based on the above comparison, it can easily be concluded that in the periods when prices were increasing, the use of FIFO method while valuing inventories will result in lower COGS thus higher profitability & taxes and higher value of closing Inventories, whereas the Use of LIFO will result in higher COGS thus lower profitability & taxes and lower value of closing stocks.
Similarly, in the periods when prices were decreasing, the use of FIFO method while valuing inventories will result in higher COGS thus lower profitability & taxes, and lower value of closing Inventories, whereas the Use of LIFO will result in lower COGS thus higher profitability & taxes and higher value of closing stocks.
Further, from the above illustration it is imperative that different valuation methods can be used to manipulate the financial results of a business.
