The method of last-in, first-out assumes that the cost of the goods purchased last is charged to the cost of goods sold first.

Last-in, first-out (LIFO) inventory costing method assumes that the cost of latest inventories acquired are the first to be recognized as the cost of goods sold.

In the example above, the cost of $5,500 Ford will be assigned to the cost of goods sold.

The weighted-average method (also called the average cost method) provides that the average unit cost is included in the cost of goods sold.

Weighted-average (average cost) inventory costing method assumes that the average cost of inventories is to be recognized as the cost of goods sold.

In order to determine the weighted-average, you need to add all the costs of the items on hand and divide the result by the number of items. In our example, the calculation is as follows: ($5,000 + $5,500) / 2 = $5,250. This amount will be charged to the cost of goods sold when an item is sold.

It is important to note that the methods described above only refer to cost flows of inventory, and usually not to their physical flows. Physical inventory flows usually follow the specific identification or FIFO rules.

A selected cost flow method has a direct effect on the cost of goods sold and gross margin numbers. Look at the table below and compare the same dealership's gross margins determined using different cost flow methods. Assume that sales are $8,000 and only one car was sold.

Illustration 1: Effect of cost flow methods on gross margin

Inventory costs are allocated between the cost of goods sold and the ending inventory at period end. Therefore, the cost flow method selected by a company also affects the balance sheet numbers. FIFO transfers the first costs to the income statement leaving the last in the balance sheet. Contrary, LIFO moves the last cost to the income statement and retains the first cost in the balance sheet. The weighted-average uses the same average costs for both income statement and balance sheet. Look at the table below to see the balance sheet ending inventory numbers under the three cost flow methods (the same example):

Illustration 2: Effect of cost flow methods on ending inventory balances