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How do I Choose the Best Inventory Method?

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  • Written By: Michael Lawrence
  • Edited By: J.T. Gale
  • Last Modified Date: 22 September 2016
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The choice of which inventory method to use can be important for a company because it generally has an impact on the balance sheet, financial statement, and taxes. A company's inventory typically includes raw materials that will be used to make products, along with goods in the process of becoming finished products and the finished products themselves. Company inventory usually comprises a significant portion of total assets. There are three main methods for calculating inventory: Last-in, First-out (LIFO); First-in, First-out (FIFO); and average cost method. Because the cost of raw materials can change over time, even during the same accounting period, companies typically need to determine what costs are associated with the revenue they earn; this can help them choose the best inventory method.

Using the Last-in, First-out method, the cost of the last unit of inventory purchased is subtracted from the price for which the company sells the finished product. The difference is the profit on the sale of the finished product. This method leaves all of the earlier-purchased raw material units in inventory, and the value of the inventory is determined using the older unit costs.

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By contrast, some companies choose the First-in, First-out inventory method. Using this method, the company determines its profit by subtracting the cost of the first unit of inventory purchased from the price for which it sells the finished product. Using this method, all of the later-purchased units of raw material are left in inventory. The value of the inventory is thus determined using the newer unit costs.

The third inventory option is the average cost method. With this approach, a company first determines the average cost of each unit in its inventory. This amount is then used to calculate profit using the same approach as the other two methods. The average cost is also used to determine the value of the remaining units in inventory.

Most companies choose which inventory method to use based on whether there is a significant overall rise in the costs of goods and services — also known as inflation. The LIFO method generally shows lower profits and inventory values, while the FIFO method typically shows higher profits and inventory values. If the economy is in a period of inflation, LIFO is generally preferred because it lowers the amount of taxes the company must pay. The opposite is true in periods of deflation.

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SZapper
Post 3

I think the average cost method sounds like the most sensible inventory cost method. That way you can get an idea of the average value of your product, since the cost of raw materials does change over time. However, that doesn't change how much it cost to make the good at the time they were made. I think the average cost method takes those factors into account.

I suppose it doesn't give you a break on your taxes or make your company look extra-profitable like the other two methods. But it seems like the best way to figure out the actual cost of doing business.

strawCake
Post 2

@ceilingcat - I see what you're saying, but I don't think you're exactly right. If a company is using a completely legal method of inventory accounting, then how can they be cheating on their taxes? In order to cheat on your taxes, you have to be something illegal!

Anyway, I can see why companies might choose different methods. For example, a company might choose one method because it makes them seem more profitable. Yes, they'll have to pay more taxes. But I think it would be easier for a company to get more investors if they seem more profitable, so there's a benefit to using that method too.

ceilingcat
Post 1

I think it's really interesting the amount of taxes a company has to pay can vary based on their inventory accounting method. Because that seems kind of shady to me!

The company is making the same amount of profit, regardless of the method of accounting they used. But one method makes it look like they are making more, while the other makes it look like they're making less. I kind of feel like companies who use the method that makes it look like they're earning less are pretty much cheating on their taxes. I guess it's legal though!

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