Choice of Inventory Valuation Methods

(Inventory Valuation Methods Compared)

It must be remembered that ‘cost’ for the valuation of inventories has to be calculated in accordance with one of the above-stated methods based on certain cost-flow assumptions. The various methods represent different views of the historical cost concept. The best method to use is one which will correctly reflect the net income through the process of matching costs against revenues. The reason is simple because the cost of production must be subtracted from revenues realized. In fact there is no method of valuing cost of goods sold and ending inventory which would reflect the complete accuracy at all time and in all situations. It is of paramount importance that the selected method should be followed consistently from year to year. Lack of consistency would frustrate year-to-year comparisons of the results disclosed by income statement. If there are generally uniform or stable prices of the goods purchased during the year, the three methods – FIFO, LIFO and Weighted Average – would approximately give the same results. But if prices of the goods purchased fluctuate significantly, the method of valuing the cost of goods sold and the ending inventory will have a direct effect on the income statement. The choice of the method would depend upon following considerations:

(i)    The use of FIFO under rising prices results in the highest inventory valuation, gross margin on sales and net income and lowest cost of the goods sold. LIFO under such conditions gives opposite results.

(ii)    Under falling prices, FIFO gives lowest inventory valuation, gross margin on sales and net income and highest value of the cost of goods sold. The use of LIFO in such conditions reserves the results.

In summary, FIFO produces a more realistic ending inventory valuation because it is close to current close. In contrast, LIFO matches the most recent costs with revenues and hence produces a better matching of expenses with revenues.

(iii)    In a period of rising prices, LIFO reports the lowest income with corresponding saving in tax (where this method is permissible); and because of the cash saving, cash outflow is less than when FIFO is used. But its effect on the balance sheet is that during inflationary conditions there is an understatement of inventories. The purpose of LIFO is to match current costs with revenues rather than earliest costs as in FIFO.

(iv)    The advocates of FIFO maintain that this method is in line with sequence of the goods sold and its ‘cost’ curve closely follows the market price trends in so far as purchase prices are concerned. However, during rising prices, FIFO mixes up inventory profits with operational profits.

(v)    Finally, the Weighted Average Method amounts for ending inventory, cost of goods sold and net income fall between FIFO and LIFO methods in their effect both on the balance sheet and the income statement. When inventory turns over rapidly, the weighted-average inventory values are almost as close to present prices as in FIFO. Weighted average reflects all of the prices as well as beginning inventory costs carried over from previous period.

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