What should an organization consider when choosing the inventory method?

There are three main approaches to inventory valuation: first-in, first-out (FIFO), last-in, first-out (FIFO), and weighted average. Specific identification is also an option, but is reserved for large or expensive items like cars, boats, and jewelry. Under FIFO, the inventory items purchased earliest in the period are considered to have been sold. Under LIFO, the inventory items purchased most recently are considered to have been sold. The weighted average approach considers the cost of all the inventory items bought during the period. When inventory turnover is high, the weighted average approach will closely match FIFO instead of LIFO.

Because the use of FIFO results in the lowest cost of goods sold and, therefore, the highest net income during periods of inflation (i.e., rising costs), it is often adopted by firms wishing to report higher net income figures. It is also most likely to be adopted by large firms, firms with more variable inventory growth, and firms having no tax loss carry forwards.

On the other hand, LIFO results in the highest cost of goods sold and, therefore, the lowest net income during periods of inflation. LIFO, then, is sought after by firms looking for lower income taxes and, therefore, increased cash flows. It is important to note that firms selecting LIFO to value their inventories must disclose the LIFO reserve, or the difference in valuation between FIFO and LIFO, in the notes to the financial statements.