What is the difference between FIFO and moving average costing methods in valuing raw materials inventory?

FIFO (First in First Out) and weighted average method are inventory valuation methods. Inventory is one of the most vital current assets and some companies operate with significant amounts of inventories. Proper valuation of inventory is essential to show effective results in financial statements. The key difference between FIFO and weighted average is that FIFO is an inventory valuation method where the first purchased goods are sold first whereas weighted average method uses the average inventory levels to calculate inventory value.

Table of Contents Show

What is FIFO?
What is Weighted Average?
What is the difference between FIFO and Weighted Average?
Summary – FIFO vs Weighted Average

CONTENTS
1. Overview and Key Difference
2. What is FIFO
3. What is Weighted Average
4. Side by Side Comparison – FIFO vs Weighted Average
5. Summary

What is FIFO?

FIFO operates under the principle which states that first purchased goods are the ones that should be sold first. In most companies, this is very similar to the actual flow of goods; thus, FIFO is considered to be the most theoretically accurate inventory valuation system among others.

E.g. ABC Ltd. is a bookstore that sells study material (books) to universities. Consider the following purchases and related prices for the month of March.

Date	Quantity (books)	Price (per book)
02nd March	1000	$ 250
15th March	1500	$ 300
25th March	1850	$ 315

From the total quantity of 4350, assume that 3500 is sold and the sale will be done as follows.

1000 books @ $ 250 = $ 250,000

1500 books @ $ 300 = $ 450,000

500 @ $315 = $ 157,500

Remaining inventory (1350 @ $ 315) = $ 425,250

FIFO is the preferred method by many organizations since the company is not likely to be left with outdated inventory under this method. Companies that use FIFO will constantly have updated market prices reflected in their inventory. The drawback of this method is that this is inconsistent with the prices quoted for customers.

Figure 01: Stock Issuance in FIFO

What is Weighted Average?

This method values inventory by dividing the cost of the goods available for sale by the number of goods, thus calculating an average cost. This helps to arrive at a value that does not represent oldest or latest units. Considering the same example,

E.g. Total number of books,

1000 books @ $ 250 = $ 250,000

1500 books @ $ 200 = $ 300,000

1850 books @ $ 315 = $ 582,750

Cost of a book ($ 1,132,750/4350) = $ 260.40 per book

Cost of goods sold (3500* $260.40) = $ 911,400

Remaining inventory (1350* 260.40) = $ 351,540

The main advantage of weighted average method is that it evens out effects of widely varying prices due to the average use of price. Further, this is a convenient and simple method of inventory valuation. However, the issue of inventory may not reflect the prevailing economic values. Another disadvantage of this method is that when the average value of inventory is divided by the number of units, this often results in an amount with decimal points that has to be rounded up/down to the nearest whole number. Thus, this does not provide a perfectly accurate valuation.

What is the difference between FIFO and Weighted Average?


FIFO is an inventory valuation method where the first purchased goods are sold first.	Weighted average method uses the average inventory levels to calculate inventory value.
Usage
FIFO is the most commonly used inventory valuation method.	Usage of weighted average method is less compared to FIFO.
Method
Inventory will be issued from the oldest available batch.	Inventory will be averaged out to arrive at a price.

Summary – FIFO vs Weighted Average

While both FIFO and weighted average are popular inventory valuation methods, companies can decide which method to use based on their discretion. The difference between the two depends on the way the inventory is issued; one method sells the goods purchased first (FIFO) and the other calculates the average price for the total inventory (weighted average). The inventory valuation records are internal for the company while its effects will be reflected in the income statement in the cost of goods sold section.

References: 1.Morah, Chizoba. “What’s the difference between weighted average accounting and FIFO/LILO accounting methods?” Investopedia. N.p., 30 Apr. 2009. Web. 23 Mar. 2017. 2.”Advantages & Disadvantages of Average Cost Method.” Chron.com. Chron.com, 29 Mar. 2013. Web. 23 Mar. 2017. 3.”Weighted Average Method.” AccountingTools. N.p., n.d. Web. 23 Mar. 2017.

4.”FIFO vs LIFO: The Disadvantages and Advantages to Inventory Valuation.” Udemy Blog. N.p., n.d. Web. 23 Mar. 2017.

Inventory Valuation Method - FIFO vs. Moving Average

What is inventory valuation?

Inventory valuation is the cost of unsold goods in a company’s inventory. It includes all costs incurred to get the item ready for sale, like material expenses, direct labour, freight, handling, import duties etc.Inventory is an important asset on the company’s balance sheet for small and medium businesses. So, it is very important to calculate correct inventory value.There are several valuation methods, but for small businesses, it is generally restricted to FIFO and Moving Average.

FIFO (First In First Out):

In FIFO it is assumed that, in a warehouse, items that arrive first, are sold first. Hence, it is calculated by summing the actual cost of the stock of an item, available in the warehouse.

Moving Average:

In Moving Average, the value of an item is the average cost weighed by the quantities available in the warehouse.

Example:

Now we will take an example and see the impact on valuation using FIFO and Moving Average. Lets assume the following transactions happened with item A:

On 03-01-2012:Stock Value as per FIFO = (10.12) + (5 * 15) = $ 195Valuation Rate as per Moving Average = (10.12 + 5.15)/(10+5) = $ 13 Stock value as per Moving Average = (15 * 13) = $ 195On 10-01-2012:12 qty sold.As per FIFO, 10 qty @ $12 and 2 qty @ $15 will been considered for sale. Stock Value for remaining stock as per FIFO = (3 * 15) = $ 45But in case of Moving Average any 12 item can be sold at an average cost $13 Valuation Rate for remaining stock as per Moving Average = $ 13 Stock value as per Moving Average = (3 * 13) = $ 39

Advantages and Disadvantages:

In real world, generally price of the item rises over time, so products that come into inventory earlier have lower cost than newer ones. That’s why using FIFO, valuation rate generally shows higher value compared to moving average, and hence higher gross profit and net income.On the other hand, since it increases gross profit and income, it also increases tax liabilities to the company.Determining the average unit cost of goods available for sale effectively smoothes any price fluctuations in a material that may occur. That’s why, if cost of any item fluctuates very regularly, it is recommended to use moving average method.

What if stock goes into negative?

Negative stock is only allowed if valuation method is Moving Average. If stock goes into negative, stock value treated as zero. When stock comes back to positive, valuation rate is again calculated for positive qty.

What happens when back-dated entries are made?

Posting date and time of any stock transaction plays a vital role in calculating stock value on a given date. If there is any back-dated entry entered in the system, then the valuation for all the future transactions from that date should be recalculated.

OneHash handles both FIFO and Moving Average and also allows you to make back-dated entries. Negative stock though is only allowed if your valuation system is Moving Average

Updated on: 21 / 12 / 2021