FIFO (First-in, first-out cost formula) assumes that items of inventory that were purchased or produced by a company first are sold first and the items remaining in ending inventory at the end of the period are those most recently purchased or produced. Thus, more recent purchase costs are assigned to the inventory asset account, and older costs are assigned to the cost of goods sold expense account.
Consider the following example: Perhaps, there are 515 DVD Players on hand at 30 June 2015, and recent purchase invoices showed the following costs:
28 June 180 DVD Players at $49.00
15 June 325 DVD Players at $48.50
31 May 200 DVD Players at $47.00
The value of ending inventory is found by starting with the most recent purchase and working backwards until all items on hand have been priced. The value of ending inventory would be $25 052.50 (being 180 DVD Players @$49 + 325 DVD Players @$48.50 + 10 DVD Players @$47).
Many proponents of the FIFO method argue that this method best reflects the physical movement of inventory, particularly perishable goods or those subject to changes in fashion or rapid obsolescence. If the oldest goods are normally sold first, then the oldest costs should be assigned to expense.
Weighted average cost formula
Under the weighted average cost formula, the cost of each item sold is determined from the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis (weighted average), or as each additional shipment is received (moving average).
Using a periodic basis, the cost of inventory on hand at the beginning of the period plus all inventory purchased during the year is divided by the total number of items available for sale during the period (opening quantity plus purchased quantity). This produces the cost per unit. For example: inventory on hand at 1 January 2015 was valued at $3439.78, consisting of 134 units at an average of $25.67 each. During the year the following purchases were made:
200 units at $27.50 = $5 500.00
175 units at $28.35 = $4 961.25
300 units at $29.10 = $8 730.00
120 units at $29.00 = $3 480.00
At the end of the year, the weighted average cost of inventory would be calculated as:
$3 439.78 + $5 500.00 + $4 961.25 + $8 730.00 + $3 480.00 = $26 111.03 ÷ 929 units = $28.11 per unit
Using the moving weighted average method, the average unit cost is recalculated each time there is an inventory purchase or purchase return.