FIFO Vs. Average Cost Method
FIFO and average cost are two methods of valuing inventory. Choosing the right method for your small business could potentially allow you to book thousands of dollars in additional or earlier profits. The main distinction between the FIFO – or first-in, first-out – and average cost method is the way each accounting option calculates inventory and cost of goods sold. Using the right method can help ensure that your small business meets customer needs by having products available when customers want them while maximizing profits.
FIFO involves selling the oldest items or those that have been in the warehouse the longest first, hence the term, first-in, first-out. The average cost method, which is sometimes called the weighted average cost, is calculated by dividing the total cost of goods in your inventory by the total number of items available for sale.
In her book, "Accounting Demystified," Leita Hart-Fanta gives the example of a business buying bags of cement to construct birdhouses: "If the price of cement is going up, the FIFO method would cause the cost of each birdbath to be the lowest cost possible." This is because by using the FIFO method, you're accounting for the fact that the bags of cement you purchased were less expensive, giving you a larger profit for some of your birdbaths. Note that with FIFO you don't have to use or resell the oldest bags of cement first: FIFO is a cost-accounting method, not an inventory-control method. You're simply taking note that you purchased X number of bags at a lower price.
Average cost, by contrast, is just that – the average cost for all of the bags of cement, regardless of what you paid for them. The average cost is the total cost of items in your inventory divided by the total number of units in your inventory. It doesn't matter if you're buying those items to use in the manufacturing process or you're simply holding the items until you can sell them: The process is the same. You're simply determining the average cost that you will apply to each item.
In an inflationary period, FIFO leads to higher profits, because you are selling goods that cost you less when you purchased them compared to more recent items that you purchased at a higher per-unit price. The effect is the opposite in a deflationary period. If prices are dropping, you should not use the FIFO method.
Average cost, though, is great if you are operating in a period of relatively low or no inflation. If prices are stable, you might as well use the average cost method because it's much simpler to calculate. However, if prices are fluctuating, either up or down, you do not want to use the average cost method because it could potentially cost you money – possibly a lot of money.
You can determine which accounting method might be best for you by calculating the value of a sample set of goods using the FIFO and average cost methods. Suppose you buy five bags of cement for $10 per unit. Then, the price increases, and you buy another five bags for $20 each. So that's:
- Five bags at $10 each = $50
- Five bags at $20 each = $100
- Total number of bags = 10
- Total cost = $150
Determining which accounting method to use can be tricky. If you use the average cost method, you have:
- Total cost of the bags ($150) ÷ total number of bags (10) = weighted average cost ($15 per bag)
If you used the cement to create birdbaths, and you sold the birdbaths at $50 each, you would earn:
- Total sales price - total cost for all units = profit, or
- ($50 x 10) - (10 x 15) = $500 - $150= $350
If you use the FIFO method, you start with the first five bags:
- Total cost of the first five bags ($50)
- Total number of the first five bags (5)
- Cost per unit for the first five bags ($50 ÷ 10 = $10 per unit)
You would then calculate the cost of the next five bags:
- Total cost of the last five bags ($100)
- Total number of the last five bags (20)
- Cost per unit of the last five bags ($100 ÷ 20 = $20)
If you sold those same birdbaths for $50 each, you would have:
- Total sales price - total cost for first five units = profit for first five units:
- ($50 x 5) - ($10 x 5) = $250 - $50 = $200 profit (for the first five bags)
Then you would calculate the profit for the second set of five bags:
- ($50 x 5) - ($20 x 5) = $250 - $100 = $150 profit (for the last five bags)
This doesn't seem like much of an accounting trick at first. Using either method, your total cost for 10 bags of cement was $150, and your total profit is $350. However, if you use the FIFO method, you book $200 profit for the first five birdbaths, whereas with the average cost method, you book only $175 in profit. This may not sound like much, but if you multiply this $25 by 10,000 items, you will book an extra $25,000 in profit earlier in the process. That's a lot of extra money to buy more supplies regardless of the cost of supplies. If prices keep going up – as they usually do – you can continue using FIFO to continue maximizing your profits.