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.
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.