Invantory Accounting: Standard Cost (Weighted Average Cost) vs FIFO/LIFO
Overview
Inventory accounting determines how the cost of goods purchased or manufactured is assigned to:
- Inventory remaining on hand, and
- Cost of Goods Sold (COGS) when inventory is sold.
When the same item is purchased at different costs over time, the inventory accounting method determines which cost is used for the items sold and which cost remains in inventory.
The three commonly discussed methods are:
- Standard Cost / Weighted Average Cost
- FIFO — First-In, First-Out
- LIFO — Last-In, First-Out
Each method can produce a different inventory value and COGS even when the physical inventory and selling prices are exactly the same.
Standard Cost / Weighted Average Cost
What is Standard Cost?
Standard Cost assigns a predetermined cost to an inventory item. The standard cost represents the expected or calculated cost of the item and is used consistently for inventory transactions.
For example, if an item has a standard cost of $10.00, inventory receipts and issues may initially be recorded using $10.00 per unit regardless of the actual purchase price.
If the actual purchase price is different from the standard cost, the difference may be recorded separately as a purchase price variance, cost variance, or another appropriate variance account, depending on the accounting system.
What is Weighted Average Cost?
Weighted Average Cost (WAC) calculates an average cost for inventory based on the total cost of inventory available divided by the total quantity available.
The basic formula is:
Weighted Average Cost = Total Cost of Inventory Available ÷ Total Quantity Available
For example:
| Purchase | Quantity | Unit Cost | Total Cost |
|---|---|---|---|
| First purchase | 100 | $10.00 | $1,000 |
| Second purchase | 100 | $14.00 | $1,400 |
| Total | 200 | $2,400 |
The weighted average cost is:
$2,400 ÷ 200 = $12.00 per unit
Therefore, inventory issued after these purchases would be valued at $12.00 per unit under a weighted-average approach.
Important distinction
Standard Cost and Weighted Average Cost should not automatically be treated as the same accounting method.
- Weighted Average Cost is calculated from actual inventory costs.
- Standard Cost is normally a predetermined cost established by the business.
However, an inventory system may use a standard cost derived from or periodically updated using weighted-average costs. If that is how your software operates, the user guide can describe the feature as "Standard Cost (Weighted Average Cost)", while explaining the distinction.
FIFO — First-In, First-Out
FIFO stands for First-In, First-Out.
Under FIFO, the costs of the oldest inventory are assumed to be sold first.
This means that when inventory is purchased at different prices, the earliest purchase costs are assigned to COGS before later purchase costs.
Example
Assume the following purchases:
| Purchase | Quantity | Unit Cost |
|---|---|---|
| First purchase | 100 | $10.00 |
| Second purchase | 100 | $14.00 |
If 120 units are sold:
- First 100 units → $10.00 = $1,000
- Next 20 units → $14.00 = $280
Therefore:
COGS = $1,280
The remaining inventory is:
80 units × $14.00 = $1,120
Under FIFO, the remaining inventory therefore consists of the more recent purchase costs.
Effect during rising prices
When purchase prices are increasing, FIFO generally results in:
- Lower COGS
- Higher ending inventory
- Higher reported gross profit
This occurs because the older, lower-cost inventory is assigned to COGS first.
LIFO — Last-In, First-Out
LIFO stands for Last-In, First-Out.
Under LIFO, the costs of the most recently purchased inventory are assumed to be sold first.
Using the same example:
| Purchase | Quantity | Unit Cost |
|---|---|---|
| First purchase | 100 | $10.00 |
| Second purchase | 100 | $14.00 |
If 120 units are sold:
- First 100 units → $14.00 = $1,400
- Next 20 units → $10.00 = $200
Therefore:
COGS = $1,600
The remaining inventory is:
80 units × $10.00 = $800
Effect during rising prices
When purchase prices are increasing, LIFO generally results in:
- Higher COGS
- Lower ending inventory
- Lower reported gross profit
This occurs because the newer, higher-cost inventory is assigned to COGS first.
Note: LIFO is not permitted under IFRS and is not permitted for financial reporting in many jurisdictions. Therefore, whether LIFO is available depends on the accounting standards and jurisdiction applicable to the business.
Worked Comparison
Consider a company that purchases inventory as follows:
| Transaction | Quantity | Unit Cost | Total Cost |
|---|---|---|---|
| Purchase 1 | 100 | $10 | $1,000 |
| Purchase 2 | 100 | $14 | $1,400 |
| Total available | 200 | $2,400 |
The company then sells 120 units.
Assuming no other costs:
| Method | COGS | Ending Inventory |
|---|---|---|
| Weighted Average | $1,440 | $960 |
| FIFO | $1,280 | $1,120 |
| LIFO | $1,600 | $800 |
Weighted Average
Average cost:
$2,400 ÷ 200 = $12 per unit
COGS:
120 × $12 = $1,440
Ending inventory:
80 × $12 = $960
FIFO
COGS:
100 × $10 + 20 × $14 = $1,280
Ending inventory:
80 × $14 = $1,120
LIFO
COGS:
100 × $14 + 20 × $10 = $1,600
Ending inventory:
80 × $10 = $800
This example demonstrates an important point: the physical inventory is identical under all three methods, but its accounting value and the resulting COGS are different.
Comparison Table
| Feature | Standard Cost / Weighted Average | FIFO | LIFO |
|---|---|---|---|
| Basic concept | Uses a predetermined standard cost or an average cost | Oldest costs are assigned to sales first | Newest costs are assigned to sales first |
| Cost calculation | Average/predetermined cost per unit | Actual historical layers, oldest first | Actual historical layers, newest first |
| Effect of price increases | Generally produces a cost between FIFO and LIFO | Lower COGS | Higher COGS |
| Ending inventory during rising prices | Generally between FIFO and LIFO | Higher | Lower |
| Gross profit during rising prices | Generally between FIFO and LIFO | Higher | Lower |
| Cost stability | High | Can fluctuate as cost layers are consumed | Can fluctuate as cost layers are consumed |
| Inventory cost layers | Usually simplified/averaged | Maintains cost layers | Maintains cost layers |
| Ease of system processing | Relatively simple | More detailed | More detailed |
| Suitable for | Businesses wanting consistent and practical inventory costing | Businesses wanting inventory valuation that generally reflects newer inventory costs on the balance sheet | Businesses where LIFO is permitted and appropriate |
| International accounting | Commonly used, subject to the specific implementation | Commonly permitted | Not permitted under IFRS |
| Physical movement required? | No | No — it is an accounting assumption | No — it is an accounting assumption |
How the Methods Affect Financial Results
The choice of inventory costing method becomes particularly important when purchase prices change.
When inventory costs are increasing
The general relationship is:
FIFO → Lower COGS → Higher Profit → Higher Inventory
Weighted Average → Middle COGS → Middle Profit → Middle Inventory
LIFO → Higher COGS → Lower Profit → Lower Inventory
Conversely, when inventory costs are falling, the relative effects generally reverse.
Therefore, the inventory costing method does not change the physical quantity of inventory. It changes how the cost of that inventory is allocated between COGS and ending inventory.
Why a Business May Use Standard Cost / Weighted Average
Standard Cost or Weighted Average Cost can be particularly useful when a business:
- Purchases the same item repeatedly at different prices.
- Wants relatively stable inventory costs.
- Has a large number of inventory transactions.
- Does not want to maintain individual cost layers for every purchase.
- Needs predictable product costing for sales and inventory management.
- Wants a practical costing method that is easier to maintain in an ERP or accounting system.
For example, if the purchase price of an item changes frequently from $9.80 to $10.20 to $10.50, using a standard or average cost can provide a more stable cost for inventory and sales transactions.
Key Difference in Simple Terms
A simple way to understand the three methods is:
Standard Cost / Weighted Average: "Use an average or predetermined cost for the item."
FIFO: "The oldest inventory cost is considered sold first."
LIFO: "The newest inventory cost is considered sold first."
The methods are therefore different ways of determining which cost is assigned to inventory sold and which cost remains in inventory.
Summary
There is no single inventory costing method that is universally best for every business. The appropriate method depends on the nature of the inventory, the frequency of inventory turnover, price movements, and the applicable accounting standards.
Standard Cost / Weighted Average Cost provides a relatively stable and practical approach and is often suitable for businesses that value simplicity and consistent product costing.
FIFO generally provides a higher ending inventory value and lower COGS when purchase prices are rising because the older, lower costs are assigned to sales first.
LIFO generally provides a lower ending inventory value and higher COGS when purchase prices are rising because the newer, higher costs are assigned to sales first. However, its use is restricted by applicable accounting standards.
Practical Impact of Choosing an Inventory Costing Method
The actual financial impact of choosing WAC, FIFO, or LIFO depends largely on how quickly inventory turns over and how much the purchase cost changes over time.
- Fast inventory turnover: If inventory is purchased and sold within a relatively short period, such as within one month, there may be little difference between WAC, FIFO, and LIFO, particularly when purchase prices do not change significantly during that period.
- Stable purchase prices: If the cost of an item remains substantially unchanged for a long period, the different costing methods will generally produce similar inventory values and COGS, even if inventory turnover is relatively slow.
- Slow inventory turnover with significant price fluctuations: If inventory is held for a long period and purchase prices change significantly during that period, the choice of WAC, FIFO, or LIFO can result in a meaningful difference in the cost assigned to COGS and the value of inventory remaining on hand. Consequently, it can also have a significant effect on reported gross profit and P/L.
In simple terms:
Fast inventory turnover + stable prices → relatively small accounting impact from the choice of costing method.
Slow inventory turnover + significant price fluctuations → potentially significant impact on inventory valuation, COGS, gross profit, and P/L.
Therefore, when evaluating an inventory costing method, businesses should consider not only the accounting method itself, but also the inventory turnover rate and the degree of cost fluctuation experienced by their products.
Ultimately, the selected inventory costing method should be applied consistently and in accordance with the accounting standards and accounting policies applicable to the business.