# Different Inventory Methods

**How does QuickBooks handle inventory?** QuickBooks uses an average cost method to value inventory. This is different from the FIFO (First In, First Out) and LIFO (Last In, First Out) inventory methods.

There are three basic methods of inventory:

- LIFO Inventory Method
- FIFO Inventory Method
- Average Cost Inventory Method

## Inventory Method Summary

This is also probably the single most confusing aspect of QuickBooks. In fact, many businesses choose not to track inventory at all in QuickBooks. However, using the QuickBooks inventory will greatly decrease accounting headaches when preparing financial statements for tax return purposes.

First let’s take a look at each of the methods of accounting for inventory:

## LIFO – Last In, First Out

The basic definition of LIFO is that the last item added to inventory is the first item to be taken out of inventory when sold. To demonstrate, think of the PEZ candy dispenser you had as a child. If you add candy to the PEZ dispenser one at a time you push the previous piece of candy further down. Then when you take out a piece of candy, you are actually taking out the last piece you put in, hence Last In, First Out.

Now we need to consider cost here. This is where inventory can get very complicated. Using our PEZ dispenser, let’s assume that it can hold 10 pieces of candy. Now, let’s assume that we buy 5 pieces of candy for $1.00 today, and load up our PEZ dispenser with those 5 pieces. So, each piece costs us .20 cents.

Now, let’s assume we got in trouble and Mom says no candy today. So, a day passes and we buy 5 more pieces of candy. Only this time we had to pay $1.50 for those 5 pieces, hence these 5 pieces cost .30 cents each.

When you take out a piece of candy, the first five pieces you take out cost .30 cents each. The next 5 pieces will cost .20 cents each. Now let’s put this in a business perspective.

Let’s say we sell 2 pieces of candy to our buddy for .75 cents.

Sales | $0.75 | |

Cost of Goods Sold | $0.60 | 2 pieces x .30 cents |

Gross Profit | $0.15 | Sales – cost |

The above takes care of the Income Statement side of the sale, now we need to look at the Balance Sheet side. We had 10 pieces of candy before we sold 2 pieces to our buddy for a total inventory cost of $2.50. Since we are using the LIFO method of inventory valuation, the two pieces we sold cost us .60 cents. So on our Balance Sheet inventory will get reduced by the Cost of Goods Sold or .60 cents.

The following diagram depicts what happens in the above example.

## FIFO – First In, First Out

The basic definition of FIFO is that the first item added to inventory is the first item to be taken out of inventory when sold. To demonstrate this, think of a Coke machine. When you load up the Coke machine with soda, the first can you put in goes to the bottom. Each subsequent can gets stacked on top of the last can. When you press the button for a soda, the first can that got put in the machine is the first can out, hence First In, First Out.

Now, let us consider cost as we did in the LIFO example above. Using our Coke machine, let’s assume that it can hold 10 cans of soda. Now, let’s assume that we buy 5 cans of soda for $1.00 today, and load up our Coke machine with those 5 cans. So, each can costs us .20 cents.

Now, let’s assume we got in trouble and Mom says no soda today. So, a day passes and we buy 5 more cans of soda. Only this time we had to pay $1.50 for those 5 pieces, hence these 5 pieces cost .30 cents each.

When you take out a can of soda, the first five cans you take out cost .20 cents each. The next 5 pieces will cost .30 cents each. Now let’s put this in a business perspective.

Let’s say we sell 2 cans of soda to our buddy for .75 cents.

Sales | $0.75 | |

Cost of Goods Sold | $0.40 | 2 pieces x .20 cents |

Gross Profit | $0.35 | Sales – cost |

The above takes care of the Income Statement side of the sale, now we need to look at the Balance Sheet side. We had 10 cans of soda before we sold 2 cans to our buddy for a total inventory cost of $2.50. Since we are using the FIFO method of inventory valuation, the two pieces we sold cost us .40 cents. So on our Balance Sheet inventory will get reduced by the Cost of Goods Sold or .40 cents.

The following diagram depicts what happens in the above example.

## Average Cost Inventory Method

The basic definition of the Average Cost method of inventory is that the average cost is the total cost of the items currently in stock divided by the number of items in stock. To demonstrate, think of the Coke machine in the LIFO example. When you load up the Coke machine with soda, it does not matter what order the cans are loaded or dispensed. The only thing that matters here is the average cost of each can of soda.

To demonstrate, let us consider the same scenario as in the previous examples. We buy 5 cans of soda for $1.00 today, and load up our Coke machine with those 5 cans. So, each can has an average cost of .20 cents. This is calculated by dividing the total cost of the items in stock ($1.00) by the total number of items currently in stock.

Now, let’s assume we got in trouble and Mom says no soda today. So, a day passes and we buy more cans of soda. This time we are going to buy ten more cans of soda instead of 5 to demonstrate the average costing method of inventory. We had to pay $3.00 for those ten new cans of soda. So we now have fifteen cans of soda that cost us a total of $4.50. The average cost would be .30 cents a can.

When you take out a can of soda, the cost for each can is .30 cents, since we are using the average cost method. Now, let’s put this in a business perspective.

Let’s say we sell 2 cans of soda to our buddy for .75 cents.

Sales | $0.75 | |

Cost of Goods Sold | $0.60 | 2 pieces x .30 cents |

Gross Profit | $0.15 | Sales – cost |

The above takes care of the Income Statement side of the sale, now we need to look at the Balance Sheet side. We had 15 cans of soda before we sold 2 cans to our buddy for a total inventory cost of $4.50. Since we are using the average cost method of inventory valuation, the two pieces we sold cost us .30 cents. So on our Balance Sheet inventory will get reduced by the Cost of Goods Sold or .60 cents.

## Summary of Inventory Methods

QuickBooks uses the Average Costing Method for Inventory. To put it simply, QuickBooks is constantly recalculating the cost of your inventory parts each time you purchase new inventory. Remember, this does not happen when you create the purchase order, but it does get re-calculated by QuickBooks when you receive items.

The FIFO and LIFO method of inventory calculation are not used by QuickBooks. FIFO represents that the first inventory item received into inventory is the first inventory item shipped out when sold. LIFO represents that the last inventory item received into inventory is the first inventory item shipped out when sold.

All three methods are recognized as legitimate inventory methods according to the IRS.