It is therefore critical that the correct method, or often a collection of different methods are used within an organisation. There are several methods for calculating the value of inventory, however the four main ones are:
1. Last In, First Out (LIFO) – The organisation’s accounts show that the most recently purchased inventory at the most recent price is used first.
2. First In, First Out (FIFO) – This method assumes that the first stock in (or the oldest inventory on-hand at the oldest prices) will be used first always.
3. Average Cost – The accounts use an average cost for items purchased, across all deliveries received within the time period set (or since the last valuation). For example:
Avg Cost = Average of all pricing across a number of deliveries ÷ total number of deliveries
4. Standard Cost – The organisation decides on a single cost for each item; it’s normal, expected cost. This cost is often set as the initial product and process cost model and maintained within Management Information System (MIS).
Inventory is generally a large part of an organisation’s assets on a balance sheet and therefore can massively impact on the overall performance of the business, so the policy of selecting the best method for the business (and maintaining consistency within methods used) is critical.
For example if there is a constantly changing pricing from a supplier on a particular part, why would the LIFO or FIFO method be used? An Average Cost (ideally) or Standard Cost would most likely be the preferred method.