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Basis for Selection of Inventory Method
(Which is the Best Inventory Valuation Method):

Learning objectives of this article:

  1. How to select an inventory valuation method among various methods. (average, LIFO, FIFO).

How does one chose among the various inventory methods( Average, LIFO, FIFO). Although no absolute rules can be stated, preferability for LIFO can ordinarily be established in either of the following circumstances:

  1. If selling prices and revenues have been increasing. faster than costs, thereby distorting income.

  2. In situations where LIFO has been traditional, such as department stores and industries where a fairly constant "base stock" is present such as refining chemicals and glasses.

Conversely LIFO would not be appropriate:

  1. Where prices tend to lag behind costs.

  2. In situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry.

  3. Where unit cost tend to increase as production increases, thereby nullifying the tax benefit that last in first out (LIFO) method might provide.

Tax consequences are another consideration, Switching from FIFO to LIFO usually results in an immediate tax benefit. However, switching from LIFO to FIFO can result in a substantial tax burden.

Often the inventory valuation methods are used in combination with other methods. For example, most companies never use LIFO totally, but rather use it in combination with other inventory valuation approaches. One reason is that certain product lines can be highly susceptible to deflation instead of inflation. In addition, if the level of inventory is unstable, unwanted inventory liquidations may result in certain product lines if LIFO is used.

Finally, where inventory turnover in certain product lines is high, the additional recordkeeping and expense are not justified by FIFO. Average cost is often used in such cases because it is easy to compute.

It is recommended that the pricing method most suitable to a company be selected and, once selected, be applied consistently thereafter. If conditions indicate that the inventory pricing method in use is unsuitable, serious considerations should be given to all other possibilities before selecting another method. Any change should be clearly explained and its effect disclosed in the financial statements.

Relevant Articles:

Classification of Inventory

Difference between Perpetual and Periodic Inventory System
Basic Issues in Inventory Valuation
Average Cost Method
First In First Out (FIFO) Method
Last In First Out (LIFO) Method
LIFO Reserve
LIFO Liquidation
Basis for Selection of Inventory Method





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