accounting may sound like a huge undertaking but in reality, it is
quite straightforward and easy to understand. You start with the inventory
you have on hand. No matter when you sell product, the value of your
inventory will remain constant based on accepted and rational methods
of inventory accounting. Those methods include weighted average, first
in/first out, and last in/first out.
Weighted average measures
the total cost of items in inventory that are available for sale divided
by the total number of units available for sale. Typically this average
is computed at the end of an accounting period.
The weighted average method
is calculated as follows:
Cost of Goods for Sale at Cost ÷
Total Number of Units Available for Sale =
Weighted Average Cost per Widget
Suppose you purchase
five widgets at $10 a piece and five widgets at $20 a piece. You
sell five units of product.
Five widgets at $10 each
Five widgets at $20 each = $100
Total cost of goods = $150
Total number of widgets = 10
Weighted Average = $150 ÷ 10 = $15
$15 is the average cost of the 10 widgets
First in, first out means
exactly what it says. The first widgets you bring into inventory will
be the first ones sold as product. First in, first out, or FIFO as
it is commonly referred to, is based on the principle that most businesses
tend to sell the first goods that come into inventory.
Suppose you buy five
widgets at $10 a piece on January 3 and purchase another five widgets
at $20 a piece on January 7. You then sell five widgets on January
Using first in, first
out, the five widgets you purchased at $10 would be sold first.
This would leave you with the five widgets that you purchased at
$20, which would leave the value of your inventory at $100.
Last In/First Out
This method, commonly referred
to as LIFO, is based on the assumption that the most recent units
purchased will be the first units sold. The advantage of last in,
first out accounting, or LIFO, is that typically the last widgets
purchased were purchased at the highest price and that by considering
the highest priced items to be sold first, a business is able to reduce
its short-term profit, and hence, taxes.
Suppose you purchase
five widgets at $10 a piece on January 4 and five more widgets at
$20 a piece on February 2. You then sell five widgets on February
The value of your inventory,
using LIFO, would be $50, since the most recent widgets purchased,
at a total value of $100 on February 2, were sold. You were left
with the five widgets valued at $10 each.