#Business and #Finance ~ FIFO, LIFO, and AVCO

13 Mar

As always, this lesson is not intended to be professional advice. This is simply lesson material for ESL students in an introductory Economics and Finance class. Posted here for their use or for helping other students. 

Although they might sound more like little dog names (“Here, Fifo!) the terms FIFO, LIFO, and AVCO are actually extremely important terms in Accounting, Supply Chain Management, and Business!

Image result for Fifo

The company wants to know, “What is our Profit this year?” “How much Money did we make?”

Hopefully, you already remember this ~

Profit = Revenue – Cost 

This sounds pretty easy!  But actually it isn’t -_- . . . . in fact each company may count their profits in a different way!

Let’s look at how this happens

~~~~~~~~~~~~~~~~~~~~~~

Most businesses do not buy all of their raw materials (原材料) at the same time. For example, a Bakery (面包店) does not buy a year’s amount of flour (面粉) at one time. They buy enough for now, then more later. Maybe a little extra if it goes on sale at some point.

Here is an example:

Bobby Bakery makes cakes (yum!), and each cake requires 1 cup of flour.

Week 1 — They buy 5,000 cups of flour for $2 each.

Week 2 — They buy 6,000 cups of flour for $3 each (the price went up).

Week 3 — They buy 3,000 cups of flour for $1 each (there was a “flour sale”).

Here is what we know so far:

  1. Bobby Bakery has bought 14,000 cups of flour total (5,000 + 6,000 + 3,000).
  2. Bobby Bakery spent $10,000 on the first 5,000 cups.
  3. They spent $18,000 on the next 6,000 cups.
  4. They spent $3,000 on the last 3,000 cups.
  5. So the total money Bobby Bakery spent was $31,000.

Next!

Week 4 Bobby Bakery sells 12,000 cakes for $4 each. How much PROFIT (利润) does Bobby Bakery make?

Revenue is easy (收入)! 12,000 cakes x $4 each = $48,000. Good!

Cost (成本) though is not so easy. . . . it depends on whether Bobby Bakery started using flour bought on Week 3 first or did they start with the old flour and then use the new flour last. The cost will be different!

Bobby Bakery used 12,000 cups of flour. Check . . . we know this.

SITUATION #1 ~ FIFO

If Bobby Bakery started with the flour from Week 1, the cost would look like this:

12,000 cups = 5,000 cups (from Week 1) + 6,000 cups (from Week 2) + 1,000 cups (from Week 3). Notice, we do not need ALL the flour from Week 3. . . we only need 12,000 cups total. In that situation, the cost would be:

5,000 ($2) + 6,000 ($3) + 1,000 ($1) = $10,000 + $18,000 + $1,000 = $29,000.

We call this system FIFO — First in, First out. It just means that we used the old flour from Week 1 first.

The Profit in the FIFO system = $48,000 (Revenue) – $29,000 (Cost) = $19,000!

SITUATION #2 ~ LIFO

Now, let’s try a different situation. What if Bobby Bakery started with the new flour from Week 3 first?

3,000 cups (from Week 3) + 6,000 cups (from Week 2) + 3,000 cups (from Week 1). Now, we do not use all the flour from Week 1 . . . we still only need 12,000 cup total. The cost would be:

3,000 ($1) + 6,000 ($3) + 3,000 ($2) = $3,000 + $18,000 + $6,000 = $27,000! 0_0

The cost is different now!! We call this system LIFO, Last in, First Out. It just means we used the newest flour first so start there.

So profit will be different under LIFO = $48,000 (Revenue) – $27,000 (Cost) = $21,000!

SITUATION #3 ~ AVCO

Finally, let’s look at a THIRD way of counting the cost.

What if Bobby Bakery mixed all the flour together. . . they do not know if it is Week 1 flour or Week 3 flour. -_- . . . Now we find the AVERAGE COST (AVCO).

5,000 ($2) + 6,000 ($3) + 3,000 ($1) = $31,000. The average cost (平均成本) per cup of flour is $2.21. Bobby Bakery needs 12,000 cups of flour. So the Average Cost of 12,000 cakes is $26,520. (Again, a new cost!)

Under AVCO, the profit would be $48,000 (Revenue) – $26529 (Cost) = $21,480

CONCLUSION

We have three different profits:

  • FIFO (we started with Week 1 flour) — $19,000
  • LIFO (we started with Week 3 flour) — $21,000
  • AVCO (we started with the average cost per cup) — $21,480

And this would be very important to know for a lot of people.  For example, the owners — I want to know if I received 21,480 or $19,000!  That seems important!  Also, the government — which profit do we use to count taxes? 

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