FIFO and weighted average are referred as two methods used for valuation of inventory in a company. Inventory valuation is important because it affects many other vital figures especially those written in the financial statements of a business e.g. cost of goods sold, gross profit, the value of closing inventory mentioned in total assets etc.
Definitions and meanings:
FIFO is an inventory valuation method in which inventory is dispatched on a first-in-first-out basis. So, inventory acquired/manufactured first is dispatched first, thus following a chronological order.
Weighted Average Method:
Weighted average method of inventory valuation follows a system of averaging costs of all the inventory and dispatching them based on a mean cost.
For example, Jeanie Autos, is a trading company that trades in tractors.The sales and purchases of tractors by Jeanie in the months of January and February are as follows:
|(Sales)/Purchase||Cost per Unit||Total Cost|
Now, if Jeanie Autos, adopts a FIFO method for valuation of their inventory, the inventory valuation for the months of January and February will be:
|Number of tractors sold||Cost per Unit||Total Cost|
|27||27 @ $25,000||$675,000||$675,000|
|24||(18 @ $25,000 +
6 @ $24,790)
$148,740) = $598,740
|18||(7 @ $24,790 +
7 @ $24,990 +
4 @ $25,050)
$100,200) = $448,660
So, the cost of goods sold based on the FIFO method would be $675,000 in January and $1,047,400 in February for Jeanie Autos. The value of closing stock at the end of month of February will be $50,100 (2 @ $25,050).
Now, if Jeanie Autos, adopts a weighted average method for valuation of their inventory which is usually perpetual, the inventory valuation for the months of January and February will be:
|Number of tractors sold||Cost per Unit||Total Cost|
So, the cost of goods sold based on the weighted average method would be $673,731 in January and $1,048,806 in February for Jeanie Autos. The value of closing stock at the end of month of February will be $49,974 (2 @ $24,987).
Difference between FIFO and average costing method:
1. Primary distinction:
The primary difference between the two methods is the cost ascertained to the inventory that is dispatched or sold by a business. In FIFO method, the basic assumption followed is that inventory which is acquired first or enters the business first will be the first to exit. This affects the cost of dispatched inventory because, irrespective of the time of dispatching inventory, the costs allocated to those inventories will be according to the earliest inventories received. In weighted average method, the inventory will be dispatched on the basis of a weighted average of costs of all the inventory present in a business at the time of dispatch. It means that for every dispatch a new cost will be calculated and allocated to the inventory if the business follows a perpetual system of inventory valuation which is more practical.
2. Impact on financial figures:
The method of inventory valuation can affect the important financial figures of a company especially revenues and profits. In a time of rising inflation, the profits for a company will be shown increased under FIFO method as compared to weighted average method, because the goods will be sold on higher prices but the cost of goods deducted will likely be the earliest and cheapest. In a time of decreasing inflation, the profit margins for a company will be higher under weighted average method as compared to FIFO method because the cost of goods sold will be an average figure under weighted average method which will be lower if costs are recorded under FIFO method.
3. Ease of implementation:
FIFO method is easier to implement as it is easily understandable by the management of a company while the implementation of weighted average method for inventory valuation is more tedious and time consuming exercise. Although, the idea of weighted average method can be understood easily there are increased chances of errors while applying it in real life.
FIFO versus weighted average method – tabular comparison
A tabular comparison of FIFO and weighted average method is given below:
|The earliest inventory received will be excluded from the business first and the cost will be allocated in accordance.||The inventory will be excluded from a business based on an average cost of all goods present in a business.|
|Impact on financial figures|
|FIFO method will report higher profits if inflation is rising and vice versa.||Weighted average method will report higher profits if inflation is decreasing and vice versa.|
|Ease of implementation|
|It is simple and straightforward and easy to apply.||It can be understood with little effort but can be complicated to implement.|
Conclusion – FIFO vs weighted average method:
The use of either method for inventory valuation do not increase or decrease the actual profit of a business entity, rather these methods are used for reporting purposes for the value of inventory purchased by the business and only report increase or decrease in terms of paper profits.A company must maintain a standard policy of inventory valuation so that it could avoid chances of creative accounting and manipulation of financial results by the management of a company.