There are three ways recognised by the IRS for valuing the cost of your inventory: FIFO, LIFO and Weighted Average Cost. We'll go through each, along with the pros and cons of each approach.
The FIFO Method
FIFO stands for "First In, First Out". This means that you always use and sell the oldest stock in your inventory first. This is commonly used with stock that has limited shelf life, as it allows you to sell the stock nearing expiry first and represents the inventory flow of many businesses in general.
If you are having trouble picturing this scenario, imagine a supermarket shelf: the employee will always add new products to the back and the customer will always take the ones from the front of the shelf. Stock continuously moves toward the front of the shelf as new stock is added / removed until it is at the front.
One disadvantage of this method is if you have a long elapsed time between the purchase of your materials and their use, costs will be calculated from old stock values which may not represent the current cost of production - this can cause a mismatch between revenue and costs and thus margin calculations can be misrepresented.
The LIFO Method
LIFO means "Last In, First Out". This means you are always using the stock most recently purchased and working back from there: your most recent material purchased is the one you will use in your most recent manufacture.
In the "supermarket shelf" example again, the employee instead adds the newest items to the front of the shelf and the customer also always takes from the front. Old stock will thus never be taken from the shelf if new stock is always added to replace the removed ones.
This method, although seeming counter-intuitive in practice (as you would always retain your old stock in inventory) it is still in use in the US, particularly for businesses in which the perceived value of the product decreases rapidly with time - an example being fashion: last seasons styles are not as covetable as this season, demand then drops along with the potential sale value.
The other rationale for this approach is that it allows you to factor in price inflation for your sales: presuming that costs always increase over time, it means that your costs of goods sold will always reflect the greatest cost paid for your materials. This can be useful when offsetting your revenue, but doesn't give a true reflection of your actual production costs. For this reason, this method is banned under international financial reporting standards, however is currently still allowable under IRS regulations for certain situations.
The Rolling Weighted Average Method
This method assumes that all inventories are being sold simultaneously from a single "pool". This method is most commonly used in manufacturing situations where materials are piled or mixed together once purchased and thus can no longer be differentiated by their exact unit costs. From 2008, the IRS declared that using rolling average costs was an allowable method for calculating inventory.
In the supermarket scenario, the shelf is now a box, whereby stock is removed by customers and added by employees randomly.
Each time an item is removed or added, the combined cost is re-evaluated and a new calculated unit price is set for all items contained in the box.
This method is supported by perpetual inventory tracking systems like Craftybase, where all adjustments and costs are tracked during the year as they occur.
If you use a periodic inventory system (i.e. a paper-based one in which you do end of year physical count) then this method will not work for your business as you require the individual changes to inventory levels in order to make these calculations.
Which inventory method to choose?
To determine which inventory method to use, take a look around at your current inventory: if your materials are mainly stored together with limited ability to distinguish the exact amount paid for each one then the Rolling Average Cost method is the best one to use for your business.
If you label and track each unit cost and then cost out each of your products separately using this information then you may be better using the FIFO method and maintain a spreadsheet to indicate your costs for each order sold.