inventory costing methods place primary reliance on assumptions about the flow of costs through an organization’s inventory accounts. There are three basic methods of inventory costing:
1) Specific identification
2) First-in, first-out (FIFO)
3) Last-in, first-out (LIFO)
The specific identification method assigns the actual costs incurred on each unit of product to that unit. This approach is used only when it is possible to track individual units of inventory from the time they are acquired until the time they are sold. When using this method, businesses must have well-designed and -maintained records that show the cost of each unit of inventory.
The FIFO method assumes that the first units of inventory acquired are also the first units sold. Under this method, businesses maintain records of the units of inventory on hand, but they do not keep track of the cost of each unit. The cost of the first units sold is assumed to be the cost of the first units acquired. The cost of the remaining units in inventory is assumed to be the cost of the most recent units acquired.
The LIFO method assumes that the last units of inventory acquired are also the first units sold. This approach is used when businesses want their reported profits to reflect current costs. The LIFO method results in higher reported profits when costs are rising and lower reported profits when costs are falling.
The choice of inventory costing method can have a significant impact on a business’s reported profits. In general, businesses will choose the method that results in the highest reported profits. However, other factors, such as compliance with tax laws and financial reporting requirements, may also influence the choice of inventory costing method.