Getting Started: Inventory Valuation

And, since these numbers can have a direct effect on a company's assets and income, it's important to understand where they come from.

COGS and Ending Inventory Valuation

The four major methods used to value a company's inventory include last in first out, first in first out, average cost and specific identification. No one method is more "correct" than any other and they each can result in a different amount. Here's a breakdown:

1. Last in First Out (LIFO): Let's go back to the sock example. The LIFO method assumes that when you sell a pair of socks, it's the last pair you bought from the manufacturer. In an economy where costs are increasing (because of inflation), LIFO results in higher COGS and lower profit. This method is attractive because it results in a lower taxable income amount.

2. First in First Out (FIFO): Under the FIFO method, the first pair of socks you sell is valued as the first you bought for your inventory. This method usually results in a higher income amount.

3. Average Cost: With the average cost method, you take the average of what you paid for all your socks, and calculate a single unit price that you can assign to every pair of socks in your inventory. If you actually manufactured the socks yourself, then the average cost method can get more complex.

4. Specific Identification: Specific identification assigns each pair of socks a unique identifier (like a serial number), so that you can track what you actually paid for it. For example, when you sell the 84th pair of socks, you can look up how much the 84th pair cost you, and assign that amount to COGS. Specific identification is more popular with companies that sell high-priced items that are easy to keep track of (like a car dealership).