There are two methods of cost inventory calculation namely, FIFO (First-in-First-Out) and LIFO (Last-in-First-Out). LIFO method has several advantages, for example; the material costs of the goods available reflect the current market prices. In addition, the method eliminates the effect of fluctuations in prices in a period of changing price levels, as it allows the income statement not to show unrealized profits. The LIFO method also indicates the effects of current market prices on the cost of production and lowers the burden of income tax during periods of rising prices, as it tends to decrease the amount of profits (Banerjee, 2006). One disadvantage of using LIFO method is that it undervalues the closing stock during the period of rising prices. The method may lead to clerical errors frequent because of price fluctuations (Banerjee, 2006). Besides, the method gives a low production charge due to the impact of falling prices.
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FIFO method has several advantages, for instance, its usefulness in times of falling prices, as it gives a better result. In addition, the method is simple to understand and is easier to operate. The material cost under FIFO, represents the actual cost of a product (Needles, Powers & Crosson, 2011). The closing stock valuation, under FIFO method, gives a closer valuation to that of the current prices. Nonetheless, FIFO method disadvantages include the frequent fluctuations of prices that can lead to a clerical error (Khan, 2007). Besides, the fact that the method is difficult to apply in cases where there are numerous numbers of inventory.
Even though, there is no suitable method between LIFO and FIFO, the use of LIFO method is appropriate for income statement calculations, while the FIFO method is suitable for the balance sheet method application (Norton, Diamond & Pagach, 2006). In the above case scenario, the use of FIFO method is suitable as it gives a higher value of $13,600 of the closing inventory as compared to LIFOLIFO’ $10,800 valuation.
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