For the elementary accounting student, calculating cost of goods sold can be an intimidating assignment. The two main methods for computing COGS (cost of goods sold) are LIFO (last in-first out) and FIFO (first in-first out).
In order to properly understand the two methods, we first need to learn how they operate, and then understand when to use them.
FIFO (First In First Out)
FIFO is a more chronological method. It is the most intuitive of the two because as humans we tend to think in linear terms. Meaning we tend to see things in succession. When we talk about U.S. history in the 20th century, we start somewhere around World War I. From there we talk about the Roaring Twenties and then World War Two. In succession, we make our way up to the presidency of Barack Obama. We dont talk first about Obama's presidency and then jump to World War ll. We talk in chronological sequence. It is the same idea when computing COGS using FIFO. Using FIFO, you charge product costs to cost of goods sold in the order in which you acquired the goods. As an example...
Suppose you acquire four pieces of wood for 4 different pieces of woodwork you plan to build. They cost you $100, $103, $99, and $200 in the order that you bought them. By the end of the period you have sold 3 of the 4. Using FIFO, you calculate the COGS as follows: $100 + $103 + $99 = $302.In total you paid $502, $302 of which is COGS and $200 of which is ending inventory.
LIFO (Last In First Out)
By comparison, LIFO tells 20th century history in reverse. Though World War l happened first, the LIFO lover starts with the presidency of Barack Obama. It takes the last product in and accounts for it first when computing COGS. With the example earlier, and still having sold 3 of the 4 products, you would compute the COGS starting with the $200 cost. So your COGS would be as follows: $200 + $99 + $103 = $402. In total you paid $502, $402 of which will be COGS and $100 of which will be ending inventory.
There are advantages to both. Many people use FIFO for two reasons. One, the ending inventory balance offers the most accurate depiction of the current cost of the goods. If I need to replace inventory, or plan to buy more of the material, the current inventory offers a good estimate of what the current rate is for the material. Second, it is the best method when the cost of the good is rising over time. When the price is rising, you can keep the price as is because you use the cheaper product first when accounting for COGS.
There are also advantages to the LIFO method. The main one is that in times of rising prices, if companies want to minimize their taxable bottom line, they should use LIFO. LIFO calculates COGS using the last in. So in times of rising prices, this means that your COGS will be higher using LIFO than it would be using FIFO.
This is just the basics of LIFO and FIFO. If you want to learn more about LIFO and FIFO, I advise you to purchase a business book about computing inventory costs.
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