FIFO, LIFO or Average Cost: Which Inventory Valuation Method is Best for Small Manufacturers?

Choosing the right inventory valuation method can be a daunting task, with implications for every aspect of your small manufacturing business. It’s not just about numbers and calculations - it’s a decision that can directly affect your bottom line, tax obligations, and ultimately, your business’s success or failure.

Whether you’re leaning towards First-In-First-Out (FIFO), Last-In-First-Out (LIFO), or the Average Cost method, we invite you to dive into this comprehensive comparison to find the best fit for your unique business needs.

Buckle up as we unravel the complexities of each method, helping you make a more informed decision.

What is an inventory valuation method?

An inventory valuation method is a system used to assign costs to the materials and products held in inventory. It determines how much each unit of inventory is worth, which directly impacts your business’s financial statements and tax obligations. There are multiple methods for calculating inventory valuation, with FIFO, LIFO, and Average Weighted Cost. being the most commonly used ones.

Each method has its own unique approach, with varying effects on financial statements and tax implications.

FIFO

FIFO stands for “First In, First Out”. This means that you always use and sell the oldest stock in your inventory first. This is commonly used with stock that has limited shelf life, as it allows you to sell the stock nearing expiry first and represents the inventory flow of many businesses in general.

If you are having trouble picturing this scenario, imagine a supermarket shelf: the employee will always add new products to the back and the customer will always take the ones from the front of the shelf. Stock continuously moves toward the front of the shelf as new stock is added / removed until it is at the front.

One disadvantage of this method is if you have a long elapsed time between the purchase of your materials and their use, costs will be calculated from old stock values which may not represent the current cost of production - this can cause a mismatch between revenue and costs and thus margin calculations can be misrepresented.

Pros and Cons of FIFO

Pros:

• Matches the physical flow of goods: For most businesses, FIFO mirrors the actual flow of inventory, making physical inventory management easier.

• Minimizes obsolescence risk: By selling the oldest items first, there’s less chance of items becoming obsolete before they’re sold.

• Reliable in stable markets: In economic environments where prices are generally stable, FIFO yields reliable gross profit margins.

Cons:

• Inflation distortion: In periods of inflation, FIFO can inflate net income because older, cheaper costs are matched against current revenue.

• High income taxes: Increased net income can lead to higher income tax obligations.

• Mismatch of costs and revenue: If there is a long time lapse between purchase and sale, costs calculated from old stock values may not represent the current cost of production, leading to distorted margins.

LIFO

LIFO means “Last In, First Out”. This means you are always using the stock most recently purchased and working back from there: your most recent material purchased is the one you will use in your most recent manufacture.

In the “supermarket shelf” example again, the employee instead adds the newest items to the front of the shelf and the customer also always takes from the front. Old stock will thus never be taken from the shelf if new stock is always added to replace the removed ones.

This method, although seeming counter-intuitive in practice (as you would always retain your old stock in inventory) it is still in use in the US, particularly for businesses in which the perceived value of the product decreases rapidly with time - an example being fashion: last seasons styles are not as covetable as this season, demand then drops along with the potential sale value.

The other rationale for this approach is that it allows you to factor in price inflation for your sales: presuming that costs always increase over time, it means that your costs of goods sold will always reflect the greatest cost paid for your materials. This can be useful when offsetting your revenue, but doesn’t give a true reflection of your actual production costs. For this reason, this method is banned under international financial reporting standards, however is currently still allowable under IRS regulations for certain situations.

Pros and Cons of LIFO

Pros:

• Reflects current cost: LIFO ensures that the cost of items sold on the income statement is based on the cost of the most recent purchases, closely matching the current market conditions.

• Tax benefits: During periods of inflation, LIFO results in higher cost of goods sold and lower taxable income, thereby reducing the income tax burden.

• Hedging against price inflation: LIFO allows businesses to keep pace with increasing costs, which can be beneficial when prices are rising.

Cons:

• Doesn’t match physical flow: LIFO often doesn’t reflect the actual flow of goods, which can make inventory management confusing.

• Increased risk of obsolete inventory: As older units remain in inventory, there’s a greater chance they may become outdated or obsolete before they’re sold.

• Distorts inventory value: The inventory value reported under LIFO may be significantly lower than the current market value.

• Unacceptable under IFRS: LIFO is not accepted under International Financial Reporting Standards, restricting its use for companies that operate or plan to operate internationally.

The Rolling Weighted Average Method

The rolling / weighted average method is most commonly used in manufacturing situations where materials are piled or mixed together once purchased and thus can no longer be differentiated by their exact unit costs.

In 2008, the IRS declared that using rolling average costs was an allowable method for calculating inventory.

In the supermarket scenario, the shelf is now a box, whereby stock is removed by customers and added by employees randomly.

Each time an item is removed or added, the combined cost is re-evaluated and a new calculated unit price is set for all items contained in the box.

This method is well supported by perpetual inventory tracking systems, where all adjustments and costs are tracked during the year as they occur.

If you use a periodic inventory system (i.e. a paper-based one in which you do end of year physical count) then this method will not work for your business as you require the individual changes to inventory levels in order to make these calculations.

More details on how rolling averages are calculated can be found in our blog post here: What is the Weighted Average Cost Method?

Pros and Cons of The Rolling Weighted Average Method

Pros:

• Accurate Costing: The rolling average method calculates the average cost of all inventory items on hand, providing a more accurate cost per unit.

• Inventory Valuation: It allows for accurate inventory valuation, reflecting the cost of goods sold more realistically.

• Less Impact from Price Fluctuations: This method is less sensitive to short-term price fluctuations, providing a smoother cost flow over time.

• Adjusts for Market Conditions: The rolling weighted average adjusts continuously for changes in inventory costs, making it more reflective of current market conditions.

Cons:

• Complex Calculations: The rolling average method requires constant recalculation whenever you purchase additional inventory, which can be time-consuming and complicated.

• Not Suitable for All Businesses: This method may not be well-suited for businesses using a periodic inventory system as it needs individual changes to inventory levels for calculations.

• Incompatible with Physical Flow: The rolling average method may not align with the physical flow of goods in some businesses.

• Potential for Misjudgment: When cost prices fluctuate greatly, it may not reflect the actual cost of the items sold or in stock.

Which inventory method to choose?

To determine which inventory method to use, take a look around at your current inventory: if your materials are mainly stored together with limited ability to distinguish the exact amount paid for each one then the Rolling Average Cost method is the best one to use for your business.

If your sale volume is low and you cost out each of your products separately then you may be better using the FIFO method and maintain a simple spreadsheet to indicate your costs for each order sold. Keep in mind with this approach that you’ll need to find a way of scaling this up should your sales increase in the future.

If your business experiences significant price fluctuations or operates in an inflationary environment, you might find the LIFO method advantageous due to its potential tax benefits and ability to reflect current costs. However, remember this method is not accepted by International Financial Reporting Standards, which could be a significant consideration if you have international operations or plans to expand overseas. As with the other methods, ensure you have the resources to manage the complexity and potential inventory management challenges that can arise with LIFO.

Using software to calculate inventory valuations

Software applications can streamline the process of inventory valuation, especially considering the complexity of calculations involved in methods such as the Rolling Weighted Average.

These tools automate the tracking of inventory levels and the costs associated with each item, updating valuations in real time as items are purchased or sold. For instance, in the Rolling Weighted Average method, the software recalculates the average cost of all inventory items every time you add or sell stock, eliminating manual effort and reducing the likelihood of errors.

Similarly, for LIFO and FIFO methods, these software solutions can automatically keep track of the order in which items were purchased or sold, ensuring accurate cost reporting. By using software for inventory valuation, businesses can achieve greater accuracy, save time, and focus more on strategic decision-making.

Craftybase is an inventory management software designed to automate and simplify the complex task of inventory valuation. If you are looking to use the Rolling Weighted Average method, Craftybase ensures accurate and real-time tracking of inventory levels and costs.

The software intuitively adjusts for changes in inventory costs, reflects cost of goods sold accurately, and will keep your inventory organized and under control.

Craftybase not only eliminates manual effort and reduces the probability of errors, but also allows your business to focus on strategic planning and forecasting.

Start your journey to hassle-free inventory management today with a free 14-day trial of Craftybase. Experience firsthand how our software can streamline your inventory valuation process and give you back time to focus on growing your business. No commitment, no credit card required. Start your free trial today!

Conclusion

The goal of an inventory valuation is to determine the cost of goods sold and the value of inventory on hand accurately.

There are various inventory valuation methods available for businesses to choose from, each with its own advantages and disadvantages.

The Rolling Weighted Average method, while complex to calculate, provides a more accurate reflection of current market conditions and can be easily automated with inventory management software such as Craftybase.

Ultimately, the inventory valuation method you choose should align with your business’s unique needs and goals.

We strongly recommend seeking professional advice to determine the best option for your business as all businesses are different and require different approaches.