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Inventory Costing Method

Inventories are purchased at different prices, we therefore need to determine our valuation method or costing method for inventories.

1. FIFO or First-In, First-Out -

A costing method that assumes that the oldest inventory purchase gets sold first. 

Effect on Net Income when using FIFO - if the inventory cost is rising (which is often the case).  Using FIFO means we charge to expense older purchases that were bought at a lower price.  Therefore, lower Cost Sales and higher Net Income. 


2. LIFO or Last-In, First-Out  

A costing method that assumes that the latest inventory purchase gets sold first. 

Effect on Net Income when using LIFO- if the inventory cost is rising (which is often the case).  Using LIFO means we charge to expense latest purchases that were bought at a higher price.  Therefore, higher Cost Sales and lower Net Income. 

IFRS does not allow the use LIFO due to potential misstatements in financial statements'. It is to avoid the potential of using LIFO to  understate a company's earnings for the purposes of keeping taxable income low. 

GAAP, on the other hand, permits the use of LIFO.


3. Specific Identification-

This is an inventory valuation that gives the most accurate costing though not on the practical side when you have a number of inventories. When that item is sold, the costs specific to that inventory is charged to Cost of Sales. Some examples of business that can use this valuation method is selling  art pieces like paintings, another example is a car dealership business. 

4. Weighted Average Cost

To calculate the weighted average cost, we get the total goods available (both in quantity and cost) by adding the beginning inventory and total purchases for a given period, We then divide the total cost by the total quantity to arrive at the average cost of inventory.
To illustrate, the the example below for the quarter ending March 31,  the weighted average cost  of $10.35.  If the quantity sold for this quarter 1200, then the Cost of Sales is 1200 x $10.35 = $12,420