Average Cost vs FIFO

Two popular ways to track Inventory Valuation are FIFO (First In, First Out) and Average Cost. LOU allows you to choose one of these two methods.

What are the differences between FIFO and Average Cost? In short, FIFO assumes the oldest Inventory is sold first and assigns the Cost of that Inventory to COGS (Cost of Goods Sold) in that order whereas Average Cost takes an average of all Costs for that item and assigns the average to COGS. The Cost assigned to COGS for an item under Average Cost will remain the same for each item sold until you Receive that item with a different Cost. At that time, the Average Cost of all quantities in Inventory will be recalculated.

FIFO

FIFO is preferred by many businesses because it is the most accurate at matching costs with revenue and can result in a lower tax burden as the older, lower cost items are expensed. However, it can also lead to higher taxable income if your retail pricing matches current costs, resulting in higher profits on older, lower cost items.

There are no calculations to find FIFO since it is tracking the Cost of each item received. As items are sold, LOU assumes the oldest are sold first and posts that Cost to COGS – first in, first out. Your ending inventory, then, is calculated using the cost of the newest items in inventory.

As costs for inventory rise, businesses typically want to sell off older inventory first since this will result in higher revenue. Keep in mind that high revenue means higher taxable income which can increase your tax burden.

The amount posted to COGS and reflected on reports will vary by transaction, depending on the Cost of the oldest received item at the time of sale.

Average Cost

Average Cost can be simpler to implement and can make accounting easier by streamlining costs when prices fluctuate. However, due to taking an average of costs, your COGS will not always accurately reflect the cost of goods sold. This average can be used to calculate COGS, gross profits, and ending inventory.

To find the Average Cost, LOU tracks the cost of each item received, adds them together, and divides by the quantity on hand to result in the Average Cost for each SKU.

Sum of Costs / QOH = Average Cost

Businesses that manufacture or sell large quantities of similar products may prefer to streamline calculating their inventory value since you don’t need to track each quantity and its cost. Similarly, if your costs fluctuate often, Average Cost can help keep inventory valuation tracking and accounting simple by averaging costs rather than tracking each cost as it is received.

The Average Cost posted to COGS and used in reporting will update every time you receive an item, even if its Cost remains the same as the last time it was received, because it is taking an average cost of the total quantity on hand.

How to Choose Which Method to Use

You and your accountant should determine which Inventory Valuation Tracking method is best for your business.

Resources

You can do a simple web search to find many online resources available to compare these valuation methods and allow you to make an informed decision. You can also check out helpful resources at irs.gov for information on the IRS requirements for valuing inventory.