What it means
The choice of method does not change how many units a business holds or how much cash it has. It changes only how the total pool of cost is divided between the income statement and the balance sheet, which in turn changes reported profit and tax.
First in, first out assumes the oldest costs are sold first, leaving the newest and usually highest costs in closing inventory. When prices are rising this reports higher profit and a more current balance sheet value.
Weighted average cost pools everything together and divides total cost by total units. It smooths out price swings and is far simpler to operate when goods are physically indistinguishable, such as fuel, grain or fasteners.
Last in, first out does the opposite of the first method, charging the newest costs to sales and leaving old costs on the balance sheet. It reduces reported profit and tax when prices rise, which is why it survives in US tax rules, but IFRS prohibits it because the balance sheet value can become badly outdated.
There is also a separate decision about record keeping. A perpetual system updates the inventory balance with every transaction, while a periodic system only recalculates it after a physical count, and the two can produce different numbers under the same costing method.
In practice
Real-world examples.
Example
A grain merchant uses weighted average cost because wheat from different deliveries is stored in the same silo. Tracking individual purchase lots would be meaningless once the grain is physically mixed.
Example
A pharmacy uses first in, first out for both physical handling and accounting, because stock has expiry dates and the oldest units genuinely must be sold first. The two lining up makes the year end reconciliation straightforward.
Example
A US steel stockholder uses last in, first out during a period of sharply rising prices, cutting its taxable profit by $900,000 for the year. Its foreign parent has to restate the figures to first in, first out for the IFRS group accounts.
Formula
Calculation
Cost of goods available for sale = opening inventory + purchases
Cost of goods sold = cost of goods available for sale - ending inventory
Weighted average cost per unit = cost of goods available for sale / total units available
A components distributor starts with no opening stock. It buys 1,000 units at $10 each for $10,000, then later buys 1,000 units at $14 each for $14,000, giving 2,000 units costing $24,000 in total. It sells 1,200 units at $25 each, generating revenue of 1,200 x $25 = $30,000.
Under first in, first out the cost of goods sold is (1,000 x $10) + (200 x $14) = $10,000 + $2,800 = $12,800, and ending inventory is 800 x $14 = $11,200. Gross profit is $30,000 - $12,800 = $17,200.
Under weighted average cost the unit cost is $24,000 / 2,000 = $12.00, so cost of goods sold is 1,200 x $12.00 = $14,400 and ending inventory is 800 x $12.00 = $9,600. Gross profit is $30,000 - $14,400 = $15,600, which is $1,600 lower. Both methods account for the same $24,000 of cost, since $12,800 + $11,200 and $14,400 + $9,600 each total $24,000.Case study
Seen in the real world.
The following is a fictional and illustrative case. Fenwick Components, an invented distributor of copper fittings, faced a year in which supplier prices jumped sharply. It began the year with 5,000 units costing $20 each, or $100,000, and bought 20,000 more at $30 each, or $600,000, giving 25,000 units available at a total cost of $700,000. It sold 18,000 units.
Under first in, first out the cost of goods sold was (5,000 x $20) + (13,000 x $30) = $100,000 + $390,000 = $490,000, leaving 7,000 units at $30, or $210,000, on the balance sheet. Under weighted average cost the unit cost was $700,000 / 25,000 = $28, giving cost of goods sold of 18,000 x $28 = $504,000 and closing inventory of 7,000 x $28 = $196,000.
The fictional company's reported gross profit differed by $504,000 - $490,000 = $14,000 depending purely on the method, with the same $14,000 difference showing in closing inventory. Nothing about the copper, the customers or the bank balance changed, which is why its lender asked for the accounting policy note before agreeing a facility based on stock values.
Watch out
Common mistakes.
- Believing the costing method describes how goods physically move, when a warehouse can rotate stock oldest first while the accounts use weighted average cost.
- Switching methods to flatter a particular year's profit, which accounting standards restrict and auditors will challenge as a lack of consistency.
- Comparing the gross margins of two companies without checking whether they use the same costing method, especially during periods of sharp price movement.
Questions
People also ask.
Which method gives the highest profit when prices are rising?
First in, first out, because it charges the oldest and cheapest costs to sales and leaves the newest costs on the balance sheet.
Why does IFRS ban last in, first out?
Because it can leave inventory on the balance sheet at costs from many years earlier, making the asset value misleading.
Can a business use different methods for different products?
Yes, provided each method is applied consistently to items of a similar nature and use, and the policy is disclosed in the accounts.
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