Distinguishing Among Inventory Management Methods: FIFO, LIFO, and WAC

During business operations, inventory management is a crucial task for determining the remaining value of goods in stock, reflecting the results of production activities, and calculating corporate income taxes. However, there are several different inventory management methods, each with its advantages, disadvantages, and varying impacts on business outcomes. In this article, we will explore the differences among the common forms of inventory management in the manufacturing industry: FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and WAC (Weighted Average Cost).

1. 1. FIFO Method (First In First Out)

The FIFO method is an inventory valuation method based on the principle of using the earliest acquired inventory first, meaning that the goods that enter the warehouse first will be the first to be sold. This method demonstrates the change in the prices of goods over time and is suitable for industries with perishable goods that require careful preservation.

To better understand this method, let's consider a specific example:

Imagine a grocery store that maintains a section for milk products. In this drawer, the first milk bottle purchased is bottle A, followed by bottle B, and finally bottle C. When a customer buys milk, the store will sell bottle A first, then bottle B, and finally bottle C. This ensures that the freshest milk is always consumed first, guaranteeing product quality.

The FIFO method has the advantage of being simple, easy to apply, and reflecting the actual value of inventory. However, this method also has the disadvantage that when prices are high, profits will be reduced, and corporate income taxes will increase.

2. 2. LIFO Method (Last In First Out)

While FIFO focuses on consuming older inventory first, the LIFO method follows the principle of "Last In, First Out." This means that the most recently acquired goods will be prioritized for use and consumption. The LIFO method is often applied in industries with non-perishable goods, where careful preservation is not necessary and there is a repetitive nature to the goods.

Let's explore a specific example to better understand how LIFO works:

Imagine a LED light manufacturing company with a production process consisting of two steps: assembly and packaging. In the assembly step, components are used to create the finished product. The product is then packaged and prepared for sale. If the LIFO method is applied, the most recent components will be prioritized for use in production, and the finished products from this production batch will be consumed or stored.

The LIFO method has the advantage that when prices increase, profits are enhanced and corporate income taxes decrease. However, this method also has disadvantages such as being difficult to apply in practice, not accurately reflecting the actual value of inventory, and not adhering to accounting principles.

3. 3. WAC Method (Weighted Average Cost)

The WAC method is an inventory valuation method based on the principle of calculating the value of inventory by dividing the total value of goods purchased by the quantity of goods purchased in an accounting period. This method is often applied in industries where there is no clear difference in quality among goods and where individual batches cannot be tracked.

To illustrate the WAC method, let's consider the following example: A construction company stocks 100 tons of steel on January 1, 2023, for 10 million VND per ton. Then, on January 15, 2023, the company purchases an additional 200 tons of steel for 12 million VND per ton. On January 31, 2023, the company sells 150 tons of steel. What are the cost of goods sold and the ending inventory value using the WAC method?

To solve this problem, we need to calculate the weighted average cost of the goods purchased. The formula is as follows:

• Weighted Average Cost = (Total Value of Goods Purchased) / (Total Quantity of Goods Purchased)

In this case, we have:

• Weighted Average Cost = (100 x 10 + 200 x 12) / (100 + 200) = 11.33 million VND per ton

Therefore, the cost of goods sold and the ending inventory value using the WAC method will be calculated as follows:

• Cost of Goods Sold = Quantity Sold x Weighted Average Cost = 150 x 11.33 = 1,699.5 million VND
• Ending Inventory Value = Quantity in Inventory x Weighted Average Cost = (100 + 200 - 150) x 11.33 = 1,699.5 million VND

The WAC method has the advantage of being simple, easy to apply, and not significantly affected by price fluctuations. However, this method also has the disadvantage of not reflecting changes in the prices of goods over time and not being suitable for industries with perishable goods that require careful preservation.

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4. 4. Comparison and Real-World Applications

When faced with inventory management, the choice between the FIFO, LIFO, and WAC methods can significantly impact how businesses assess and manage this crucial asset. Below is a comparison and practical application of these three methods.

Comparison among FIFO, LIFO, and WAC:

• - Price Fluctuations: FIFO and LIFO contrast in their response to price fluctuations. While FIFO is suitable for a rising price environment, LIFO is appropriate when prices decrease over time. WAC serves as a middle-ground solution that can reflect price changes more realistically.
• - Profit and Financial Reporting: LIFO can generate profit manipulation effects in financial reporting during periods of rising prices. FIFO typically yields lower profits during price increases, but better reflects the actual value of inventory. WAC provides an average view of profits and inventory value.
• - Transparency and Management: FIFO is often more transparent in tracking production and outgoing orders, facilitating efficient inventory management. LIFO can lead to a LIFO squeeze effect where rising prices inflate the value of inventory, posing management challenges. WAC helps neutralize price fluctuations but can also introduce confusion in inventory management.

Real-World Applications:

• - Food Industry: In the food industry, FIFO is often preferred due to perishable inventory items requiring consumption in chronological order. For example, managing fresh fish involves prioritizing the sale of earlier arrivals.
• - Pharmaceutical Industry: In pharmaceuticals, FIFO-based inventory management is critical to ensure drugs with short expiration dates are consumed first.
• - Electronics Industry: In electronics, LIFO can be applied when component prices decline over time, creating profit manipulation effects in financial reports.
• - Construction Industry: In construction, WAC might be a reasonable choice as material prices frequently fluctuate without a specific trend.

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The choice between inventory management methods depends on various factors, including price fluctuations, financial goals, and reporting requirements. FIFO often better reflects reality in an environment of rising prices. LIFO is suitable when prices gradually decrease over time and can create profit manipulation effects in financial reports. WAC is typically a middle-ground solution that reflects fluctuations in prices and materials.

The choice of inventory management methods not only impacts financial reporting but also reflects business philosophy and objectives. FIFO, LIFO, and WAC have broad applications in various industries and can be customized to fit the specific business circumstances of each company. Choosing the appropriate method plays a crucial role in ensuring transparency and accuracy in inventory management and business operations.

Regardless of the chosen inventory valuation method, real-time data recording and accurate calculations are paramount. Maintaining detailed spreadsheets for each SKU can become inefficient and time-consuming, especially for large enterprises with dozens, hundreds, or even thousands of SKUs across multiple locations and stores. Therefore, we recommend using more intelligent automated software capable of accommodating all valuation methods you apply. This software will continuously update calculations and meet all business requirements.

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If you need more information or have any questions, please feel free to contact us using the information below. We are ready to support your understanding and implementation of inventory valuation software, helping your business operate efficiently and successfully.

EnterSoft Software Solutions Joint Stock Company

Email: info@entersoft.com.vn - kinhdoanh@entersoft.com.vn

Phone: 0985.200.060

Website: www.entersoft.com.vn