4.6: Impact of Inventory Methods on Financial Position

Inventory valuation methods do more than determine how much a company paid for products. These methods shape key financial indicators and affect business decision-making. In environments where inventory costs fluctuate, the accounting method selected can influence reported profits, taxes, and even stock prices.

Key Valuation Methods

The First-In, First-Out (FIFO) method assumes that older, often cheaper, inventory is sold first. In times of rising prices, this lowers the cost of goods sold (COGS) and inflates net income and ending inventory values. Conversely, Last-In, First-Out (LIFO) assigns the most recent, and typically higher, inventory costs to COGS. This lowers reported income but can reduce tax liability in inflationary periods. Finally, the Weighted Average method blends all unit costs into a single average, smoothing out price fluctuations and reducing volatility in financial statements.

To illustrate, suppose a retailer buys 100 units at $20 and then 100 more at $30. If it sells 150 units, FIFO would result in a lower COGS than LIFO, while the weighted average would land between the two. That one accounting choice alters gross margin and inventory valuation, numbers that are critical for stakeholders interpreting financial health.

Strategic and Regulatory Implications

Under U.S. GAAP, companies can choose between FIFO, LIFO, and Weighted Average. However, international standards (IFRS) prohibit LIFO, creating divergence in reported profits across jurisdictions. Analysts often adjust for these differences when comparing firms globally.

Beyond compliance, businesses may align their method with broader goals like minimizing taxes, appealing to investors, or matching cost flow with physical flow. Regardless of motive, inventory valuation remains a central factor in financial analysis.

Inventory valuation methods affect the cost of goods sold, net income, and a company's financial position.

For example, consider Tools Depot, a company that complies with U.S. GAAP.

Early in January, it buys drills at fifty dollars each. Later, the price rises to sixty dollars.

If the selling price is seventy dollars per unit and Tools Depot uses the FIFO method, it first sells the lower-cost drills bought in January.

Using FIFO results in a lower cost of goods sold, a higher net income, and a greater inventory value on the balance sheet.

If the company uses the LIFO method, it first sells the higher-cost drills.

This leads to a higher cost of goods sold, lower net income, and a lower valuation for the remaining inventory.

If the company adopts the Weighted Average method, it calculates the average cost of fifty-five dollars per unit.

This average is used for the cost of goods sold and ending inventory.

Each method paints a different financial picture of the company's performance.

Investors and analysts must consider the chosen method when evaluating a business's performance.