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The Differences of Fifo, Lifo and Average Methods in Inventory Accounting

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The Differences of Fifo, Lifo and Average Methods in Inventory Accounting
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Definition of Company InventoryCompany inventory is the product/goods owned by the company. Which of these products will be resold or for use by the company itself. Because of the importance of this element, it is necessary to record inventory.

Technically there are two forms of company inventory recording. The first is recording using a perpetual system and recording using a periodic physical system. The company determines which system policy will be used to record its company's inventory.

From the two recording systems, namely periodic and perspective, of course, there will be different possibilities for each company in recording them. This is because this recording system is used according to the type of business that is carried out or in the business by each company. At the time of recording the inventory, the company will also determine the costs needed or used from the inventory.

Then how do you determine the cost of inventory?

In this article, we will explain a little about what methods you can use in determining inventory. Here's the review.

FIFO Method

The FIFO method assumes that the cost of goods purchased for the first time will be considered as goods that will be sold again for the first time. Under the FIFO method, and ending inventory is also considered the most recent cost of goods purchased.

The FIFO method also assumes that the goods that can be sold as a result of the orders are the goods they buy. Therefore, the goods that have been bought for the first time are the first items to be sold, and the remaining goods or ending inventory) are included in the final cost. 

Because in determining income, the costs that were previously matched with the income received and the new costs are used for the assessment of the balance sheet.

The FIFO method is consistent with the actual cash flow since the merchandise owner tries to sell the old inventory the first time. FIFO method is the method most commonly used in inventory valuation.

FIFO method is very often not seen directly in the physical flow of an item because the taking of goods from the warehouse is more based on the arrangement of the goods. That way, the FIFO method is more visible in the calculation of the cost of goods. 

In the FIFO method, the cost used in the first purchase of goods is known as the Cost of Good Sold (COGS). For the price calculation, the price of the stock item from the previous transaction will be used.

The First In First Out or FIFO method was first introduced in financial accounting as a method of valuing inventory. The price that is used as the basis for assessing the inventory of goods can be the old price or the new price.

In the FIFO method, the inventory of goods that will go out for production activities is based on the price according to the first entry rule. So that in the assessment of the remaining inventory, it means that the price is based on the new price or the price in the last order.

LIFO Method

The LIFO method is a costly expense that comes from the last purchase and provides the longest cost on the inventory account. There are several ways of implementing the LIFO method. Because each variation results in varying numbers in raw material costs incurred, ending inventory costs and profits. Therefore it is important to follow the established procedures consistently.

Pros:

  • Easy to equalize the cost at this time with an income now, if prices rise, the price of finished goods conservative
  • Operating profit is not tainted by the profit or loss from price fluctuations
  • If prices fluctuate, it can flatten an annual profit

Disadvantages:

  • Contrary to the physical flow actually
  • Not be able to show the potential of services real/old cost.

Average Method

In this method, a product cost at the beginning of the process is added to the production costs that will be incurred in the current period divided by the equivalent unit of the product to produce a weighted average cost of goods.

The cost of goods produced by the product after the first product is the cumulative cost of goods, which is the sum of the cost of the one product added to the next product concerned.

Comparison of Methods in Inventory Accounting

a. FIFO Method 

  • Produces a low cost of goods sold
  • Inventory value in financial statements is more relevant
  • The company's profit is much greater

b. LIFO Method

  • Produces a low good sold 
  • It is the cost of easy to compare costs or costs with income
  • If prices increase, the price of goods automatically more conservative
  • Company operating profit does not depend on price fluctuations
  • Tax more economical

c. Average Method 

  • Produces a high ending inventory
  • During periods of inflation or price increases, the use of the FIFO method will result in this but in a downturn in economic conditions, it will be the opposite.
  • Generates high cost of goods sold.
  • Results in low gross profit. 
  • Results in low ending inventory

Obtain results between the FIFO method and the LIFO method for the three concepts that have been described.

Thank you for visiting my blog and read some articles here. Hopefully it will useful to you.

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