Comparing Inventory Costing Methods

The results for calculating the cost of goods sold (COGS) and ending inventory varies for each of the different costing methods.

While the sales amount may be the same across the board, the COGS, gross profit, and ending inventory differ between the alternatives. In each example the goods were always sold for $3 each. In each scenario 12 units were sold, and, therefore, the total amount of sales would be $36 for each.

However, the differences can be seen with the COGS calculation:

• Under FIFO, for COGS, the oldest costs were used, which would typically be the least expensive costs.
• Under LIFO, for COGS, the newest costs were used, which are typically the most expensive costs.
• Under Weighted Average, for COGS, average costs were used, so the cost per unit fell somewhere between the highest cost and the lowest cost.

To review, gross profit is calculated by subtracting the COGS from the sales amount. These calculations are represented in the table. FIFO has the lowest costs and, therefore, the highest gross profit. LIFO has the highest costs and, therefore, the lowest gross profit. Weighted average falls in the middle.

Next, consider the costs of ending inventory. Because FIFO uses the earliest, least expensive costs to calculate COGS, the most expensive costs remain in the ending inventory. FIFO's ending inventory is the highest. LIFO uses the most recent, most expensive costs to calculate COGS. Therefore, the least expensive costs remain in its ending inventory. LIFO has the lowest ending inventory cost. As always, the weighted average falls in between the FIFO and LIFO. These assumptions are based on times of rising prices for all inventory purchases.

Traditionally, when thinking about the cost of goods and valuing inventory, the assumption is that costs will normally increase. Because of inflation and other economy-related events, society normally experiences cost increases. Based on this, the relationship of costs between the various cost structures usually follows the typical process as outlined. The COGS for FIFO is the lowest, and LIFO is the highest.

In the unlikely event that costs are constant—that is, costs do not increase—then the COGS, gross profit, and ending inventory would be the same under each alternative. Without fluctuation in the costs, the oldest costs would be the same as the newest cost.

In the most unlikely scenario, if costs decrease over time, then the previous assumptions would be reversed. In this example, if the cost of 1 unit decreased from $1.25 to $1.00, then the FIFO costing method that uses the oldest costs would have the highest COGS. Remember that it is not based on the individual costs or on which are the least or most expensive. FIFO says that the oldest costs are used first. In the case of decreasing cost, the oldest costs would be the most expensive. Conversely, for LIFO, which uses the newest costs, the COGS would be the lowest. The newest cost is now the lowest in this case. It is important to remain objective when it comes to costing inventory. Although it is not common, depending on the industry, there could be periods of constant or decreasing costs.