Since inventory purchase costs and manufacturing conversion costs vary over time, companies must use some inventory valuation method to allocate costs between the cost of goods sold and closing inventories. Such a method is called cost formula (IFRS) and cost flow assumption (US GAAP). A method that allocates more material and conversion costs to the cost of goods sold would result in lower gross profit, lower net income, lower taxes, and lower closing inventories.
IFRS allows three inventory valuation methods: specific identification, first-in-first-out (FIFO), and weighted average. US GAAP allows an additional method, the last-in-first-out (LIFO) method. A company must apply the same inventory valuation method to inventories of similar nature, however, it can apply different valuation methods to items of different natures.
Specific identification is used for inventory items that are not interchangeable while FIFO, weighted average and LIFO are most appropriate when there is a large number of interchangeable items. While specific identification traces the cost of each item, other methods require some cost flow assumption. If inventory prices are constant, all methods would yield the same result, but this is rarely the case. Specific identification is also appropriate for very expensive or unique items. This method matches flow with the actual physical flow of goods.
First-in, first-out (FIFO)
FIFO assumes that the oldest unit is sold first. Hence, the cost of goods sold includes the cost of the beginning inventory plus the cost of the earliest items purchased and the closing inventory includes the cost of the most recent purchases or production. In a period of rising (declining) prices, this causes closing inventories to be higher (lower) and COGS to be lower (higher).
Weighted average cost
The weighted average cost method allocates the total cost to COGS and closing inventories based on the weighted average cost of inventories which equals the total cost of goods available for sale (opening inventories plus inventories purchase/produced) divided by total units available for sale.
Last-in, first-out (LIFO)
LIFO is allowed only under US GAAP. It is the exact opposite of FIFO. It assumes that most recent items purchased or produced are sold first. In a period of rising prices, it causes COGS to be higher, gross profit, net income, income taxes and closing inventories to be lower, and vice versa.
Comparison of inventory valuation methods
In an environment of declining inventory prices and constant or increasing inventory quantities, FIFO would assign a higher cost to COGS as compared to other methods. This would result in lower gross profit, lower operating profit, lower profit before taxes and lower closing inventories. Alternatively, in an environment of rising inventory prices and constant or increasing inventory levels, LIFO would assign a higher cost to COGS resulting in lower gross profit, lower operating profit, lower net income, and lower closing inventories.
Under the FIFO method, closing inventories most closely reflect current replacement cost (because they consist of the more recent purchase) but under FIFO, the cost of sales represents the current replacement cost (because most of the current purchases are included in COGS).