How does the subsequent measurement of inventories work?

The individual valuation of inventories is complex and costly. For this reason, various methods of simplifying valuation have been developed. This article explains FIFO, LIFO, and the average cost method.

Each asset in the balance sheet is assigned a value. This corresponds to the adjusted initial valuation, which is the acquisition or production costs minus the change in value over time. The principle of individual valuation applies. As a result, the value of each asset must be determined separately. This approach can be associated with significant effort. Especially with inventories, determining the actual value is difficult due to varying market and acquisition prices. Therefore, there are various methods that simplify the valuation.

First-in-First-out method (FIFO)

In the First-in-First-out method (FIFO), it is assumed that the inventory items that were purchased or produced first will also be sold first. Suppose a company had an inventory of 10 pieces at a value of 10 CHF each at the beginning of the year. During the financial year, the company purchased new inventory items twice. Once 15 pieces at 12 CHF each and once 20 pieces at 18 CHF each. At the end of the year, there are still 22 pieces in stock. What is the value of the inventory? According to the FIFO method, the value of the inventory corresponds to the price of the 22 most recently purchased inventory items. In our example, the inventory is worth 20 times 18 CHF plus 2 times 12 CHF, which equals 384 CHF. On average, this results in a value of 17.45 CHF per piece.

Last-in-First-out method (LIFO)

Unlike the FIFO method, in the Last-in-First-out method (LIFO), it is assumed that the most recently purchased inventory items are sold first. For the above example, this means that the value of the inventory corresponds to the price of the 22 items purchased first. This results in a value of 10 times 10 CHF plus 12 times 12 CHF, which totals 244 CHF. Each individual piece in the inventory is therefore worth an average of 11.10 CHF. It becomes evident that FIFO and LIFO lead to significantly different results, as the effects of the methods depend on the developments of prices and inventory levels. The FIFO method has the advantage of leading to a current valuation of inventory assets. In contrast, the LIFO method allows for a current valuation of cost of goods sold. The LIFO method is not permissible under IFRS accounting principles, as it leads to an understated profit declaration.

Average method

The third possible valuation method is called the weighted or moving average method. In this method, the value of each piece corresponds to the average price of all inventory items available at the beginning of the year or purchased during the financial year. In the example, the value of all pieces is 10 times 10 CHF plus 15 times 12 CHF plus 20 times 18 CHF. Thus, the value of all 45 pieces is 640 CHF, and the average price of each individual piece is 14.20 CHF. In this case, our inventory has a value of 22 times 14.20 CHF, or 312.40 CHF. As the name suggests, the average cost method results in a value between that of the FIFO and LIFO methods.

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