Your accounting system setup can have a lasting effect on your business. The settings and methods you deploy will ultimately impact multiple areas of your operation, and each requires careful consideration if you are to realize your best chances for success.
One of the most important decisions that you can make involves your inventory methodology. Essentially, there are four different inventory accounting options, each of which are covered below – they are specific identification, weighted average, LIFO and FIFO
Specific identification inventory method lists all items in your accounting system at their actual cost and is typically used for the larger business expenses such as equipment or vehicles. The drawback to specific identification is that it can get complicated if you have hundreds of items to track.
Weighted average inventory method lists items such as commodities that are easily interchangeable or physically indistinguishable. Using this method, all similar items are priced using an average of the cost of all such related items in your inventory. The drawback to weighted average is that it doesn’t always accurately track what you paid for the individual items.
FIFO (or first in, first out) inventory method lists your oldest inventory item as the first used, resulting in ending inventory that is valued at a cost closer to the current prices (as prices generally rise over time). The drawback to FIFO is that the cost of goods is usually lower since older cheaper items are being tracked, which potentially skews the books.
LIFO (or last in, first out) inventory method lists your newest inventory items as the ones being sold, resulting in more expensive items being tracked. This produces a balance sheet with a higher cost of goods and a lower value of goods. The drawback of LIFO is that your profits are lower than if FIFO inventory methods are used.
The key to properly using any of these methods is understanding your business and the impact they will make. If your inventory costs are stable and steady or on the rise, then LIFO is the better choice. Companies with larger inventories and increasing costs appreciate the way LIFO results in lower profits and taxes and higher cash flow. If your inventory costs are falling, then FIFO is the better choice. Companies seeking more accurate inventory account valuations appreciate the way FIFO more accurately tracks a higher value of inventory.