Invantory Accounting: Standard Cost (Weighted Average Cost) vs FIFO/LIFO

Overview

1. Inventory accounting determines how the cost of goods purchased or manufactured is assigned to:
   1. Inventory remaining on hand, and
   2. Cost of Goods Sold (COGS) when inventory is sold.
2. 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.
3. The three commonly discussed methods are:
   1. Standard Cost / Weighted Average Cost
   2. FIFO — First-In, First-Out
   3. LIFO — Last-In, First-Out
4. Each method can produce a different inventory value and COGS even when the physical inventory and selling prices are exactly the same.

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Standard Cost / Weighted Average Cost

What is Standard Cost?

1. 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.
2. 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.
3. 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?

1. Weighted Average Cost (WAC) calculates an average cost for inventory based on the total cost of inventory available divided by the total quantity available.
2. The basic formula is:
   1. Weighted Average Cost = Total Cost of Inventory Available ÷ Total Quantity AvailableFor 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.

1. Weighted Average Cost is calculated from actual inventory costs.
2. Standard Cost is normally a predetermined cost established by the business.
3. 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.

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FIFO — First-In, First-Out

1. FIFO stands for First-In, First-Out.
2. Under FIFO, the costs of the oldest inventory are assumed to be sold first.
3. This means that when inventory is purchased at different prices, the earliest purchase costs are assigned to COGS before later purchase costs.
4. 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.

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LIFO — Last-In, First-Out

1. LIFO stands for Last-In, First-Out.
2. Under LIFO, the costs of the most recently purchased inventory are assumed to be sold first.
3. 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

1. When purchase prices are increasing, LIFO generally results in:
   1. Higher COGS
   2. Lower ending inventory
   3. Lower reported gross profit
2. 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.

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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

Inventory Costing Method	Average Cost / Cost Calculation	COGS	Ending Inventory
Weighted Average	$2,400 ÷ 200 = $12 per unit	120 × $12 = $1,440	80 × $12 = $960
FIFO	Oldest costs are issued first	100 × $10 + 20 × $14 = $1,280	80 × $14 = $1,120
LIFO	Newest costs are issued first	100 × $14 + 20 × $10 = $1,600	80 × $10 = $800

Result at a Glance

Method	COGS	Ending Inventory	Gross Profit*
Weighted Average	$1,440	$960	Middle
FIFO	$1,280	$1,120	Highest
LIFO	$1,600	$800	Lowest

*Assuming the same sales revenue and no other cost differences.

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.

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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

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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.

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Why a Business May Use Standard Cost / Weighted Average

1. Standard Cost or Weighted Average Cost can be particularly useful when a business:
   1. Purchases the same item repeatedly at different prices.
   2. Wants relatively stable inventory costs.
   3. Has a large number of inventory transactions.
   4. Does not want to maintain individual cost layers for every purchase.
   5. Needs predictable product costing for sales and inventory management.
   6. Wants a practical costing method that is easier to maintain in an ERP or accounting system.
2. 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.

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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.

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Changing the Inventory Costing Method

1. A business may decide to change its inventory costing method, for example, from FIFO to Weighted Average Cost (WAC), after reviewing its inventory management and accounting requirements.
2. Such a change should not be treated simply as changing an option in the accounting system. The business should first determine whether the change constitutes a change in accounting policy under the accounting standards applicable to the business.
3. Where retrospective application is required, the historical inventory balances and related Cost of Goods Sold (COGS) may need to be recalculated using the new costing method. The resulting differences may affect historical gross profit, inventory balances, and opening retained earnings or other equity balances.
4. The number of historical years that need to be considered is not necessarily three years. It depends on the applicable accounting standards, the financial statements being presented, and whether retrospective application is practicable.
5. For example, if a company has used FIFO for several years and decides to adopt WAC, it may need to:
   1. Determine the effective date of the change.
   2. Recalculate the relevant historical inventory balances using WAC.
   3. Determine the differences in inventory valuation and COGS.
   4. Determine the resulting effect on profit and retained earnings/equity.
   5. Make the appropriate accounting adjustments or restatements.
   6. Establish the corrected opening inventory balance in the accounting system.
   7. Process subsequent inventory transactions using WAC.

Important: Changing the inventory costing method in the accounting system does not, by itself, correct previously reported financial statements. Historical accounting adjustments should be reviewed and approved in accordance with the company's accounting policies and applicable accounting standards.

For this reason, businesses should consult their accountant or auditor before changing from FIFO, LIFO, or another inventory costing method to WAC.

Summary

1. 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.
2. 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.
3. 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.
4. 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

1. 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.
   1. 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.
   2. 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.
   3. 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.