With SIMMS 2012 Inventory Management software you can select the three standard valuation methods to apply to your stock:
1) First-in, First-out (FIFO): With FIFO, your cost of goods sold is based upon the cost of material bought earliest, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to the item’s current replacement cost. During periods of inflation, using FIFO will result in the lowest estimate of cost of goods sold among the three methods, and simultaneously, the highest net income.
2) Last-in, First-out (LIFO): With LIFO, your cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, using LIFO will result in the highest estimate of cost of goods sold among the three mehods, and simultaneously, the lowest net income.
3) Weighted Average: With the weighted average method, your inventory and cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this method will more closely resemble FIFO than LIFO.
Comparatively. companies choose the LIFO approach for the tax benefits during periods of high inflation, and research suggests that businesses with the following characteristics are far more likely to select LIFO: more variable inventory growth, rising prices for raw materials and labor, an absence of other tax loss carry forwards, and large size. When companies move from FIFO to LIFO in valuing inventory, there is usually a drop in net income and a concurrent increase in cash flows (due to tax savings). The reverse is true when businesses move from LIFO to FIFO.
Considering the cash flow and income effects of inventory valuation methods, comparison of businesses using different methods is imprecise. An adjustment that can be made for these differences: LIFO users specify in a footnote the difference in inventory valuation between FIFO and LIFO — referred to as the LIFO Reserve. This “margin” is then used to adjust the beginning and ending inventories, and subsequently the cost of goods sold and, thus, to restate income based upon FIFO valuation.
No one valuation method is perfect for every situation, but by knowing the characteristics of your company, you can choose a valuation method that best suits the situation. Combined with the fact that investors are not limited to just using one method, they will often perform several valuations to create a range of possible values or average all of the valuations into one.