About ten days ago I was contacted by a small manufacturer about issues they were having with their QuickBooks Enterprise 'Inventory' valuation. After considerable discussion, it seems that they decided to change their 'inventory cost' method from QuickBooks 'Average cost' to the QuickBooks Advanced Inventory 'FIFO' (first-in, first-out) method.
They simply didn't understand how QuickBooks computes 'FIFO' as contrasted with how it computes 'Average cost'. While I had a few Enterprise clients over the years who chose to use the 'FIFO' cost methodology after Intuit introduced it as part of the 'Advanced Inventory' suite, the vast majority remained on 'Average cost,' so I never really had to explain this very often.
In addition, I never covered the topic in-depth when teaching Enterprise Advanced Inventory at various QuickBooks conferences and workshops, as I just assumes that most accounting-types knew the fundamentals of 'FIFO' vs. 'Average cost.'
Nevertheless, my interaction over the phone call I mentioned earlier gave me reason to believe that perhaps this was a good topic for a 'Monday Minute' on Desktop, even though this is longer than a "minute's read."
QuickBooks Desktop - Average Cost
I'm not even certain that it's fair for me to assume that everyone understands the 'Average Cost' methodology that QuickBooks Desktop products (Pro, Premier or Enterprise) use, except when the Enterprise (only) Advanced Inventory FIFO option is turned on. I also think it's important for QuickBooks users to understand how the QuickBooks Average Cost method is different from the 'traditional method' to determining "average cost of inventory."
Traditional 'Average Cost' Methodology
Under Generally Accepted Accounting Principles (GAAP), the traditional approach to computing average cost is to add up the cost of the units of a specific inventory item you have purchased. You then count the number of units purchased. You then divide the total cost of the units you purchased by the number of units you purchased.
This 'Average cost' method computes a true average cost of all the items you have purchased for inventory, not just the items you currently have on hand. This method has the advantage of simplified verification because it's not impacted by sales of items.
QuickBooks 'Average Cost' Methodology
The QuickBooks method differs from the 'traditional method' described above in that QuickBooks adjusts the number purchased and the total purchase cost for each inventory item by the value and quantity of any sales that have taken place. In other words, it is computing only the "average cost of items on hand.'
Looking at this method a little more closely, QuickBooks maintains a count of the quantity of each item purchased, but it also maintains the value of each item purchased. When it comes time to calculate average cost, QuickBooks calculates average cost by dividing asset value by quantity on hand. QuickBooks then uses the ‘computed’ average cost to determine the COGS applied for the quantity of each item appearing on a sale, or consume (as in the case of an ‘Assembly Build.’)
Even though QuickBooks doesn't calculate the value of the Inventory (current) Asset account as the sum of each inventory item’s average cost multiplied by the quantity on hand in your company file at the time of the computation as would be the case with the 'traditional average cost' method, the QuickBooks approach is still GAAP compliant for average costing.
QuickBooks Enterprise (Advanced Inventory) FIFO Methodology
QuickBooks Enterprise is the only version of QuickBooks Desktop that offers First-in, First-out (FIFO) inventory valuation as an optional preference within the Advanced Inventory settings. FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first.
GAAP makes that assumption that FIFO computations are based on the assets with the oldest costs are included in the income statement's cost of goods sold (COGS). The remaining inventory assets are matched to the assets that are most recently purchased or produced.
This method is favored among manufacturers because of how it reflects costs and inventory in inflationary markets and times of increasing prices. In those situations, because FIFO assigns the oldest costs to the inventory being sold or consumed, those costs tend to be lower than the most recent inventory purchased at inflationary prices.
The result is the lower cost of goods sold means higher net income for the business, while at the same time the higher (inflationary impacted) inventory on hand will have a increased valuation of inventory on the balance sheet.
Until the release of the QuickBooks Enterprise Advanced Inventory FIFO option, QuickBooks had no way of tracking inventory value on a FIFO basis since it involved tracking of item purchases on a date as well as a cost basis and recording each time the cost of such items changed over time.
But the Enterprise FIFO option now offers QuickBooks users with an entirely different approach than the QuickBooks (Desktop) Average Cost method.
The QuickBooks Enterprise FIFO method does not use average cost of an item to determine COGS; instead, it assumes that the units you sell in a particular sale are the ones that you acquired earliest and that are still in stock – thus, first in, first out. The ones you buy first are the first ones out the door.
If the price that your suppliers charges you for inventory is constant, and doesn't vary as time goes by, then there is no difference between computing either Inventory Valuation or COGS using average cost or using FIFO. But when your acquisition costs change, as is typical, perhaps even over short periods of time, there can be dramatic differences between average cost and FIFO.
The mechanism behind the scenes is FIFO lot tracking (also called 'FIFO cost bucketing') in which QuickBooks records the cost of each item every time it is purchased, and when purchased in multiple quantities, it tracks the number purchased at each specific cost. This allows for a group of items to be costed based on that lot cost. (Do not confuse this with QuickBooks Enterprise Lot-number tracking. While the terminology appears similar, the behind-the-scenes functionality is different.)
Compare and Contrast QuickBooks Average Cost with QuickBooks Enterprise FIFO Cost
To see how these two methods compute cost, and differ in the cost information they record, let’s look at a comparative example:
- You purchase six (6) used Chevy Pickups at an Auto Auction at a cost of $15,000.00 each ($90,000.00 total); and five-days later you purchase three (3) additional Chevy Pickups from another Auto Action at a cost of $17,000.00 each ($51,000.00). Since you haven’t yet had any sales the total value of this inventory is $141,000.00.
- QuickBooks would tell you that the present Average Cost of the Heavy-duty pumps with motors is $15,666.66667 [$90,000.00 + 51,000.00 / 9].
- After all 9 Chevy Pickups have been received on your used vehicle lot, you sell 7 of the Pickups. QuickBooks would tell you that the Cost-of-Goods-Sold value for the sale would be equal to $109,66.66669 (7 X $15666.66667].
- On the other hand, FIFO would tell you that you sold 6 Chevy Pickups costing $15,000.00 and 1 Chevy Pickup costing $17,000.00 so the COGS for the sale would be $107,000.00 [(6X $15,000) + (1X $17,000).
- Your Inventory valuation for the remaining 2 Chevy Pickups would be $34,000.00 using FIFO and $31,333.33334 using Average Cost.
Effects of Conversion from Average Cost to FIFO:
Now let’s assume that these three transactions, the two purchases of Chevy Pickups, and the one sale of Chevy Pickups, are the only 3 transactions in a file being converted from an ‘average cost’ to a FIFO.
- There are no problems associated with the conversion of the first purchase of six (6) Chevy Pickups. The historical record shows that the Inventory value of the purchase was $90,000.00 based upon the fact that the average cost for these 6 items was the same as the actual cost of $15,000.00 each.
- But when the 2nd purchase is converted from average cost to FIFO a problem arises. Even though there are 6 Pickups in stock valued at $15,000 each, a change occurs in average cost when the 3 additional Pickups are purchased at $17,000 each. The total value of the asset is $141,000.00 but the average cost has become $15,666.66667. While FIFO also records the asset value of the inventory at $141,000.00 it preserves the ‘cost lots’ as 6 at $15,000.00 and 3 at $17,000.00
- And when the sale transaction is converted, the variation due to method is enhanced. Using Average Cost, the 7 units sold had a COGS of $109,666.66667; but using FIFO the 7 units now have a COGS of $107,000.00. The COGS of this transaction decreased under FIFO by $2,666.66667. The Profit & Loss for the sale (and the period in question) also changed.
- And when we look at the remaining Inventory balance, its valuation also reflects an issue associated with the conversion. Using Average Cost, the 2 remaining units are valued at $31333.33334, but under FIFO the remaining inventory is valued at $34,000.00. The Inventory Asset valuation increased by a difference of $2,666.66667. The Balance Sheet has just changed.
We only had 3 transactions in our history, and there are already differences in both the Balance Sheet and Profit & Loss Statement.
What do you think would happen if your Dealership had 200 different vehicles, purchased in lots of 3 to 10 vehicles of the same type at a time, and involving tens or even hundreds of transactions that must be converted. The variations can be significant.
Your accountant will likely have a way to hand handle the problems of conversion based on the most expeditious method to adjustment the two records appear to match after conversion. And, since switching from Average Cost to FIFO can have a significant impact on the financial statements, business switching must consider how reporting the gain or loss as a line item within the financials will be performed along with how it should be disclosed the in the footnotes to the financial statements.
The impact in terms of gain or loss within a company's financials is also the reason why permission from the Internal Revenue Service to change your inventory valuation method must be obtained. In many cases you must report the effects, or potential effects, upon your financial periods for the period of change and any such changes that are carried forward into the current or future periods.
So, even though changing methods might be as simple as 'clicking a preference' in one software package, or migrating from one software version to another, the results could be significant in terms of your financial statements and IRS filing status.