When managing inventory, choosing the right valuation method can significantly impact a company’s profitability. Two common methods are FIFO (First In, First Out) and AVCO (Average Cost). Each method has distinct implications for profit, especially when dealing with fluctuating prices. In this blog post, we’ll explore these methods in an inflationary and deflationary context through a simulated example, helping you understand which might be better for your business.
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Simulation: Inflationary and Deflationary Periods
To illustrate the effects of FIFO and AVCO, we simulate 20 data points representing inventory costs. The first 10 units are from an inflationary period, and the last 10 units are from a deflationary period. We will compare profits using both methods.
Data Setup
Costs
-
Inflationary Period (Units 1-10):
- Unit 1: $10
- Unit 2: $12
- Unit 3: $14
- Unit 4: $16
- Unit 5: $18
- Unit 6: $20
- Unit 7: $22
- Unit 8: $24
- Unit 9: $26
- Unit 10: $28
-
Deflationary Period (Units 11-20):
- Unit 11: $28
- Unit 12: $26
- Unit 13: $24
- Unit 14: $22
- Unit 15: $20
- Unit 16: $18
- Unit 17: $16
- Unit 18: $14
- Unit 19: $12
- Unit 20: $10
-
Sales Price: $40 per unit
Profit Calculation
Let’s calculate profits based on selling 5 units at the end of each period.
1. Inflationary Period
-
FIFO:
- COGS: $10 + $12 + $14 + $16 + $18 = $70
- Revenue: 5 units × $40 = $200
- Profit: $200 - $70 = $130
-
AVCO:
- Average Cost: ($10 + $12 + $14 + $16 + $18 + $20 + $22 + $24 + $26 + $28) / 10 = $18
- COGS: 5 units × $18 = $90
- Revenue: 5 units × $40 = $200
- Profit: $200 - $90 = $110
2. Deflationary Period
-
FIFO:
- COGS: $28 + $26 + $24 + $22 + $20 = $120
- Revenue: 5 units × $40 = $200
- Profit: $200 - $120 = $80
-
AVCO:
- Average Cost: ($28 + $26 + $24 + $22 + $20 + $18 + $16 + $14 + $12 + $10) / 10 = $18
- COGS: 5 units × $18 = $90
- Revenue: 5 units × $40 = $200
- Profit: $200 - $90 = $110
Summary
The following table summarizes the profits for FIFO and AVCO in both inflationary and deflationary periods:
| Period | Method | COGS | Revenue | Profit |
|---|---|---|---|---|
| Inflationary | FIFO | $70 | $200 | $130 |
| Inflationary | AVCO | $90 | $200 | $110 |
| Deflationary | FIFO | $120 | $200 | $80 |
| Deflationary | AVCO | $90 | $200 | $110 |
Conclusion
The choice between FIFO and AVCO can significantly affect profitability, especially during periods of fluctuating prices.
- In an Inflationary Period: FIFO typically results in higher profits due to the use of older, less expensive inventory.
- In a Deflationary Period: AVCO often leads to higher profits by averaging out the costs.
Given that most of the products will fall in in the inflationary case it would be best to utilize FIFO inorder to maximize the profit realized.