Understanding Weighted Average vs. FIFO vs. LIFO

Weighted Average vs. FIFO vs. LIFO: An Overview

When it comes time for businesses to account for their inventory, businesses may use the following three primary accounting methodologies:

• Weighted average cost accounting
• Last in, first out (LIFO) accounting
• First in, first out (FIFO) accounting

Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Depending on the situation, each of these systems may be appropriate.

Weighted Average

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.

To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.

First In, First Out (FIFO)

The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. When a business uses FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

Last In, First Out (LIFO)

The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that, although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Weighted Average vs. FIFO vs. LIFO Example

Consider this example: Suppose you own a furniture store and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let’s assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:

Example: 200 chairs at $10 per chair = $2,000. 300 chairs at $20 per chair = $6,000. Total number of chairs = 500

Weighted Average Cost

Cost of a chair: $8,000 divided by 500 = $16/chair. Cost of Goods Sold: $16 x 100 = $1,600. Remaining Inventory: $16 x 400 = $6,400

First In, First Out Cost

Cost of goods sold: 100 chairs sold x $10 = $1,000. Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

Last In, First Out Cost

Cost of goods sold: 100 chairs sold x $20 = $2,000. Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000