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Inventory Valuation Methods: Specific Identification, FIFO, LIFO & Weighted Average

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  • 0:46 Inventory Valuation
  • 1:59 Specific Identification
  • 2:57 First-In, First-Out
  • 4:12 Last-In, First-Out
  • 5:22 Weighted Average
  • 6:56 Lesson Summary
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Lesson Transcript
Instructor: Sherri Hartzell

Sherri has taught college business and communication courses. She also holds three degrees including communications, business, educational leadership/technology.

This lesson introduces you to the cost flow assumption methods of specific identification: FIFO, LIFO, and weighted average. You will also learn how to compute inventory in a perpetual system using the methods of FIFO, LIFO, and weighted average.

Perpetual Inventory Systems

Mega Irrigation, a large irrigation wholesale store, is looking to switch from a periodic inventory system, where they update financial records for merchandise transactions at the end of a period, to a perpetual inventory system, which will allow them to continually update records for merchandise transactions. Management at Mega Irrigation believes that this will allow them to keep more accurate and up-to-date records of their inventory that is available to be sold to their customers and what specific inventory has already been purchased. The perpetual system will tell Mega Irrigation the exact amount of inventory on hand at all times and what they need to restock to meet customer demand.

Inventory Valuation

Perhaps the most significant goal of accounting for inventory is to have an accurate assessment of costs and sales. Inventory valuation allows a company to provide a monetary value for items that they have in their inventory. This information permits a company to properly evaluate expenses and revenues on their financial statements so that they can make sound business decisions.

Items contained with Mega Irrigation are constantly being sold, restocked, and in some cases, changing in cost. Because of all of these changes, Mega Irrigation must select a cost flow assumption method to move the cost of items within its inventory to its costs of goods sold. The cost of goods sold refers to the cost of merchandise sold during a specific period of time. Cost flow assumptions under a perpetual inventory system include:

  • Specific identification
  • First-in, first-out
  • Last-in, first out
  • Weighted average

Once implemented, Mega Irrigation must consistently follow its stated cost flow assumption. Let's take a look at each of these cost flow assumptions a bit more to help Mega Irrigation choose one that is best suited for their needs.

Specific Identification

Specific identification is used to track and cost specific and identifiable inventory items that are either in or out of stock on an individual basis. This is done with items a company has identified via RFID tag, stamped receipt date, or serial number. The system is designed to specifically allow Mega Irrigation to identify the cost of any inventory item with an ID number.

The best advantage with this method is the high level of accuracy to the cost of the inventory on the balance sheet. The disadvantage of this system is the time it takes to enter large quantities of inventory and their prices. Specific identification is typically a practical solution for companies with expensive and unique inventory. This is not the case for Mega Irrigation; therefore, we will jump to the next cost flow assumption method, known as FIFO.

First-In, First-Out

FIFO is an acronym for first-in, first-out and means that the oldest inventory items are recorded as sold first. Essentially, FIFO assumes that inventory items are sold in the order in which they are acquired: inventory items bought first are the first ones to be sold, and inventory items bought later are sold later. Thus, the cost of inventory reflected to the balance sheet represents the cost of inventory that was purchased most recently.

As an example, let's say that Mega Irrigation has purchased 10 sprinklers at $10.00 and 20 sprinklers at $20.00. At the end of the accounting period, the irrigation wholesale sells five sprinklers at $10.00. Remaining inventory is 5 sprinklers at $10.00 plus 20 sprinklers at $20.00 for a total remaining on the balance sheet of $450.00.

FIFO is used by many companies but is most useful when inventory items have a short shelf life or expiration date and need to be sold quickly, such as in the food industries. Because irrigation parts have a long shelf life, we can move on to the next method, known as LIFO.

Last-In, First-Out

LIFO is an acronym for last-in, first out and assumes that the most recent inventory items purchased are the first ones to be sold, and inventory items purchased first are sold last. As a result, LIFO comes closest to matching current costs of goods sold with revenues when compared to other cost flow assumption methods, such as FIFO or weighted average.

Using the same example as FIFO, let's look at it using the LIFO method. Remember, Mega Irrigation had purchased 10 sprinklers for $10.00 and then 20 sprinklers for $20.00. At the end of the accounting period, Mega Irrigation had sold five sprinklers at $20.00. Remaining inventory will look like this when using the LIFO method: 15 sprinklers at $20.00 plus 10 sprinklers at $10.00. The balance sheet will show $400.00.

This method is generally used because it helps to reduce income tax. A little interesting fact is that the United States of America is the only place you can legally use the LIFO accounting method.

Weighted Average

The final cost assumption method for Mega Irrigation to consider is the weighted average. The weighted average method, also known as average cost, involves computing the weighted average cost per unit of inventory sold at the time of sale; it assumes that inventories are sold simultaneously.

The weighted average method is useful in companies where inventory items are piled or combined together in such a way that they cannot be separated to assign a specific cost to the individual units within it. It is also a good alternative when a company's accounting system lacks the sophistication needed to track inventory items under the LIFO and FIFO methods.

To calculate using the weighted average method, divide the total cost of items in inventory available for sale by the total number of units available for sale. Let's look at our example. Again, Mega Irrigation had purchased 10 sprinklers for $10.00 and then 20 sprinklers for $20.00. At the end of the accounting period, they had sold five sprinklers. The total number of sprinklers is 30 for a cost of $500.

To calculate the ending inventory balance using weighted average, start by dividing the total cost by total number of sprinklers. In this case, it is $500 divided by 30 sprinklers, equaling $16.67 per sprinkler. The remaining inventory is 25 at $16.67, which is $416.67 in remaining inventory on the balance sheet.

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