 In order to determine the value of inventory, the quantity of goods is only half the calculation. The other half is cost. So quantity times cost equals the total value of inventory. So what is the cost of inventory items? You will soon discover that that is not an easy question to answer. There are four methods to cost inventory. Specific unit cost, first in, first out, last in, first out, and average cost. A company can use any of these methods to account for its inventory. Specific unit cost method is also known as the specific identification method. With this method, a company knows exactly which items were sold and exactly the cost of the items. This costing method is best for businesses that sell unique, easily identifiable inventory items, such as real estate, cars, or jewels. But any business that has low sales volume and a wide range of prices and costs could use this method. This method uses the specific cost of each unit of inventory to determine costs of goods sold and the value of the remaining items in inventory. One of the things we will see over and over with the topic of inventory valuation is that we need to know the cost of inventory so we can record the sale of goods journal entry as shown here. So which method is best for businesses that have high volume sales and a very small range of price and costs? Well, any of the three cost flow assumptions are fine. These methods are cost flow assumptions because we don't know and are not tracking the exact item sold or the exact cost of the item sold. Let me be clear by what I mean. We know which items sold, let's say a gallon of milk, but the exact gallon of milk and the exact cost of the one specific gallon of milk isn't something most businesses are going to track. So they assume that the gallon sold was the first one purchased or they assume that the gallon sold was the last one purchased or they assume the gallon sold was some average of all of the gallons that they had on hand. That's how these cost flow assumption methods are used. Under FIFO, which stands for first in, first out. With this inventory costing method, the cost of goods sold is based on the oldest purchases. So the first in is the first out of the warehouse. Under the FIFO method, companies are assumed to sell their oldest inventory first, therefore their ending inventory comes from their most recent purchases. Most physical goods flow this way. Almost every perishable item in a grocery store physically moves like FIFO. The oldest milk is in the front of the dairy case. But that doesn't mean that all grocery stores use FIFO to value their inventory. Remember, they can use any method they want. When a company makes a sale using FIFO, the costs of goods sold is assumed to be the oldest item purchased. FIFO is the opposite of FIFO. Under FIFO, which stands for last in, first out, this costing method ending inventory comes from the oldest costs, meaning the first purchased in the period. The costs of goods sold is based on the most recent purchases. Those are the newest costs. And that is, the last one in is the first one out of the warehouse. When a company makes a sale using FIFO, the costs of goods sold is assumed to be the newest item purchased. Under average cost inventory, businesses compute an average cost per unit. Ending inventory and costs of goods sold are then based on the same average cost per unit. Under the average cost method, an average price is calculated and applied to all goods. Before we learn why companies choose one method over another, let's recall that there are two methods to track inventory, perpetual and periodic. Since the perpetual method of tracking inventory keeps a running total of the inventory units and values, the perpetual inventory record is often used to do this, albeit automated nowadays. The perpetual inventory record tracks the purchases and sales of units at cost and revalues ending inventory after each transaction. We'll see this in detail when we look at the examples of the different valuation methods. So which method should we use to value inventory? Well, it depends. FIFO is the most popular inventory costing method. LIFO is the next most popular and average cost is third. Here are the benefits of each. During a period of rising prices, and if we think of the history of prices, they're always rising if the range of time is big enough. So during a period of rising prices, FIFO results in the lowest costs of goods sold, the highest gross profit, the highest net income and the highest ending inventory value. That's why this is the most popular method. LIFO results in the highest costs of goods sold, therefore the lowest gross profit, the lowest net income, the lowest taxable income and the lowest ending inventory. The tax benefit is why this is the second most popular method. Average costs fall somewhere in between these two. So if maximizing net income is most important, you choose FIFO. If minimizing tax liability is the most important thing, then you choose LIFO. And you choose average if you want some of the benefits of both. And that concludes this video, but I encourage you to watch the example videos on calculating costs of goods sold and ending inventory with FIFO, LIFO and average costs.