The assets that a business purchases and holds for resale are called inventory. The three major inventory valuation methods are LIFO, FIFO and Weighted Average.
Under the last in, first out inventory (LIFO) method, the cost of the last goods received are charged to cost of goods sold and matched with revenue from sales.
When first in, first out inventory (FIFO) method is used, the items in the beginning inventory are assumed to be sold first. Sales are assumed to come in the order in which they are purchased allowing the costs of the last items received are assigned to the ending inventory and the remaining costs.
When weighted average inventory is used, the unit prices of the beginning inventory and of each purchase are weighted by the number of units in the beginning inventory and each purchase. The total of these amounts is then divided by the number of units available for sale to find the weighted-average cost per unit.
In a changing market where prices are rising or falling each method gives a different result. Weighted average costs tend to smooth out price fluctuations. FIFO provides an inventory valuation on the balance sheet that mostly approximates current replacement cost. LIFO causes the last costs incurred to be assigned to cost of goods sold, therefore resulting in a better matching of current costs with revenues on the income statement. Weighted average costs tend to smooth out price fluctuations.
Example: If purchase prices are rising in a period, FIFO results in the lowest cost of goods sold, highest gross profit, and the highest net income. LIFO results in the highest cost of goods sold and the lowest gross profit, and the lowest net income. The weighted average method falls between FIFO &