SWOT Analysis of Costing Methods
Hannah Lacey
Liberty University
Accounting 311
Abstract
This essay will explore give an analysis of the various costing methods used in Management Accounting, and propose an understanding of the strengths, weaknesses, opportunities, and threats of each methods. The four methods that will be discussed are LIFO (Last in first out), FIFO (First in first out), Weighted Average, and Specific Identification. These four methods are all very different in the realm of managerial accounting, and the degree of practicality of these methods depends on the place of business.
SWOT Analysis of Costing Methods
Costing methods are one of the most intriguing topics in the realm of Management Accounting. As controversies and debates rage, it is important to understand the different methods often utilized, and how these methods should be managed in a place of business.
Last in, First out
The costing method of Last in first out (LIFO), is a cost method where the latest products purchased are the first products to be expensed in cost of goods sold. The biggest strength of LIFO is that it offers a major tax advantage to businesses. When inflation is occurring in the economy, LIFO will cause a higher cost of goods sold and a lower balance of remaining inventory. Since cost of goods sold increase, net income will decrease and cause a smaller tax liability. A weakness of LIFO is that it can create a group of extremely old inventory that never gets sold because the business is constantly selling the items that they have just received. Additionally, LIFO can be very difficult to maintain because it requires more intricate recordkeeping. Companies that use the Last in, first out method have a huge opportunity to save money through the leeway of income tax advantages. A threat to this method is that although LIFO offers a large tax break, it is not a recommended costing method to businesses who are wishing to expand internationally. According to Accounting Standards Code 330-10-30-9 under GAAP, a company should utilize the accounting method that best and most clearly reflects “periodic income.” (Generally Accepted Accounting Principles) This provides substantial freedom for companies to increase their after-tax revenues based on inventory costs.
According to the International Financial Reporting Standards (IFRS), businesses are not permitted to use methods that may distort the reporting of financial statements. Unless specifically excepted as “not ordinarily interchangeable for goods and services produced,” all inventory must be accounted for using the FIFO or weighted-average cost method. (International Accounting Standards Board) Additionally, companies must display consistency with the method selected. LIFO is, therefore, disqualified as a costing method due to the potential of distorting net income during times of inflation. Many various companies are known for using the last in first out method, due to the large tax advantage offered to those who decide to utilize it.
First in, First out
The costing method of first in first out (FIFO), is a cost method where the most dated products purchased are the first products to be expensed in cost of goods sold. The biggest strength of FIFO is that it is a more realistic costing method. For lack of better words, it makes sense. The products that are the oldest need to go first so that the company can reduce obsolescence and spoilage, which in turn can help planning and forecasting. A weakness of FIFO is that it can create inaccurate depiction of costs when material prices are continually increasing. However, when inflation is occurring in the economy, FIFO has the opportunity to increase the value of inventory and also increase net income. By doing this, a company will be showing large assets and net income which can in turn attract potential investors and lenders. A threat to this method is that although FIFO is more realistic, companies do not benefit from the tax advantages as they do with LIFO. One of the largest expenses in a business is income taxes, and reducing your tax liability can often create a substantial financial benefit. The majority of food companies are most likely to use the first in first out costing method due to the spoilage that can happen when newer items are sold before older items. Additionally, other companies with quickly expiring inventory (such as florists), take advantage of the first in first out method.
Weighted Average
The weighted average cost method is most frequently used in manufacturing business where products are piled and mixed together and cannot be differentiated. An example of this would be factories producing mass amounts of small, indistinguishable items. Additionally, many chemical and oil companies use weighted average since chemicals bought four months ago cannot be distinguished from those bought yesterday, as they are all jumbled together. Many farms and agricultural businesses also use the weighted average method since anything that is mass harvested cannot be individually counted. The method specifically calculates an average cost per unit at each point in time after a purchase. A strength of the weighted average is method is that the computation is simple and fairly easy to understand. Furthermore, this method is cost effective as less time is spent evaluating inventory. Unfortunately, weighted average also holds a weakness in that it is not as updated as other methods such as FIFO. However, weighted average is accepted under the International Financial Reporting Standards (IFRS), which gives companies the opportunity to internationally expand.
Specific Identification
The specific identification method refers to the tracking and costing of inventory based on the flow of specific, identifiable inventory items in and out of stock. This method is applicable when individual items can be clearly identified, such as with a serial number. This method holds a high degree of accuracy, since you can constantly track the date an item was sold, along with the price and cost of goods sold. Unfortunately, the method of specific identification is highly impractical for many businesses. This method is normally restricted to unique, high-value items that need differentiation. However, Specific Identification does give companies the opportunity to be extremely accurate in the flow of costs almost exactly corresponds to the flow of inventory. A large threat to businesses using this method is that it can cause an increase in payroll and a reduction of inventory. It can be very time consuming to track inventory based on individual units and you might need more employees to help keep up the inventory, which would increase payroll costs. Additionally, when companies track inventory based on individual units, they are restricted to using only smaller inventory quantities. According to IFRSs, paragraph 23 of IAS 2 requires the use of a specific identification inventory costing method for “items that are not ordinarily interchangeable and [for] goods or services produced and segregated for specific projects.” (International Accounting Standards Board, pp. 23-2)Various companies are known for using specific identification including furniture stores, vehicle manufacturers, and museums or art galleries.
Ethical Concerns
Many experts in this field believe that many companies are not morally ethical when valuating inventory. However, people who oppose that statement would argue that if something is technically allowed, then they should be able to do it with a clean conscience. For example, many people use LIFO due to the tax advantage it gives, however it often skews the ending net income figure to appear to be lower during times of inflation. Personally, I believe the best option in these scenarios is to practice benevolence. In its simplest form, benevolence means we should do the right thing all the time no matter what the cost. In management accounting, we will find that benevolence and goodwill are especially important when dealing with the valuation of inventory. Additionally, benevolence requires the absence of an egocentric or profit seeking motive. It requires that goodwill be done out of the kindness of your heart, not because you are seeking further gain or self-fulfillment. The AICPA Code of Professional Conduct states that “CPAs are to act with a mission of serving public interest, demonstrating commitment and honoring public trust. An accounting professional therefore should do well to the public with a no personal profit-making motive. Professionalism should be basic in their work. They should act to serve the public interest instead of their personal interest.†(American Institution of Certified Public Accountants, 2014) This means that it is our personal job as accountants to serve our clients and the public in the most honorable and noble way possible. Additionally, Section 56 of the code indicates that “A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.†(American Institution of Certified Public Accountants, 2014) This portion of the code indicates that it is the responsibility of a CPA to not only uphold the ethical standards outlined, but also strive to better develop the quality of service to customers and the general public. All of this goes to say that if our methods of valuating inventory are profit seeking and self-fulfilling, as CPAs we are not upholding ourselves to the standards placed before us.
Conclusion
This paper has presented four different costing methods that will be utilized in the career of managerial accounting. It has also give strengths, weaknesses, opportunities, and threats of each of these methods, and given examples of companies that apply these methods. As accountants, it is imperative that we recognize how these costing methods can affect not only financial statements, but also the business as a whole.
Bibliography
American Institution of Certified Public Accountants. (2014). AICPA Code of Professional Conduct. New York, NY: American Institute of Certified Public Accountants, Inc.
Generally Accepted Accounting Principles. (n.d.). Accounting Standards Code. 330-10-30-9.
International Accounting Standards Board. (n.d.). International Financial Reporting Standards. 23-2.