Amy has a master's degree in secondary education and has taught math at a public charter high school.
A Financial Statement
If you run your own company, then you will need to prepare regular financial statements so you can see how your business is doing financially. Your financial statements are also required for your taxes. We define financial statements as those records that show your purchases and sales for a specified period of time. If you are doing your yearly taxes, then your financial statements are those that show your purchases and expenses for the tax year.
Now, how much profit you show on your financial statement can actually be different depending on the type of costing method you choose to valuate the cost of your inventory. We define costing method as the method to determine the cost of your inventory. In this lesson, we'll look at the three different costing methods along with their impact on your financial statement.
Pretend that you are the owner of a shop specializing in fancy dishes. Your inventory consists of lots of fancy dishes. Let's see how the different costing methods can change how much profit you show on your financial statement.
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The first method is FIFO or first-in, first-out. With this method, you price inventory according to the oldest purchase. So if you received inventory on Monday for $10 each, Tuesday for $12 each, and Wednesday for $13 each, this method assumes that the inventory you received on Monday will sell before the inventory on Tuesday. Your inventory cost will go from $10, to $12, to $13 as you sell your items from oldest to newest. Grocery stores generally use this costing method as older items are sold before the newer items. This prevents food products from expiring before being sold.
This method can actually increase the profit you show on your financial statement. How so? Well, this method does not take into account inflation. Think about that. Say you purchased some sets of fancy dishes for $20 per set last year. This year, that same set of dishes is now worth $25 each. Using the FIFO method, though, you would show that your inventory still costs $20 per set. Your profit will look higher. For example, if you sell your dishes for $40 per set, at the current value of $25 per set, you make a profit of $40 - $25 = $15; but on your financial statement, you show a profit of $40 - $20 = $20, since you are using the value of the dishes from last year when you purchased them.
The second costing method is LIFO or last-in, first-out. With this method, your inventory is priced according to the most recent inventory purchase. So, using the same example of receiving inventory on Monday for $10 each, Tuesday for $12 each, and Wednesday for $13 each, this method will have your inventory costing $13, $12, and then $10 as you sell your products from newest to oldest.
Some companies prefer the LIFO method because it provides for more tax benefits. The tax benefits come from using the most recent inventory cost instead of the oldest cost. Because of inflation, you will actually show a smaller profit on your financial statement since your latest inventory cost will usually be higher than the inventory cost of your older inventory. Using the same dishes example, say you purchased your dish sets for $20 last year. This year, they are worth $25. Using the LIFO method, you note down the cost of your inventory as $25 per set. Selling them for $40, you note that you get a profit of $40 - $25 = $15 per dish set on your financial statement. In reality though, you get a profit of $40 - $20 = $20 since you only paid $20 for the dishes last year.
The third method is the weighted average method. This method calculates the average cost of each of your products. It divides the total you paid for your inventory by the number of items purchased. This method will give you an inventory cost that is more aligned to inflation since it includes prices before and after inflation.
How does this impact your financial statement? During times of inflation, your average cost per product will be higher, thus decreasing the profit you show on your financial statement.
Let's review. Financial statements are those records that show your purchases and sales for a specified period of time. When it comes to deciding how much your inventory costs you, there are three different costing methods. We define costing method as the method to determine the cost of your inventory. Here is a summary of the three methods and how each impacts your financial statement:
|Costing method||Financial statement impact|
|FIFO - first-in, first-out||Higher profits in times of inflation|
|LIFO - last-in, first-out||Lower profits in times of inflation|
|Weighted average - average cost of inventory||Profits more aligned to inflation levels|
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The Effects of Financial Statements on Costing Methods
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