Choice of assumptions regarding the lot from which units of material are fusty chosen, or units first moved out gives rise to a few methods.
(a) FIFO Method with FIFO standing for FIRST IN FIRST OUT, postulates the assumption that the inventories which are received first move out first. Hence, the inventories which remain unsold are those acquired later. Though the assumption is sound in respect of lesser deterioration in inventory before it is moved out, or at least comparable deterioration (when stored) in all items of inventory before they are moved out, the method does not seem to be logical when prices are continuously rising; that there are no seasonal ups and downs in prices though there may yet be rise in prices over, say, yearly cycles as the years progress. In a simple way of explaining this situation, one may see that the cost of goods readied for sale would also have to be assigned increasingly costlier with time, and, if sale price is to be held fixed, the profit margin per unit will continuously decrease with time. In a more professional way, one says that this method leads to "inventory profits", which is explained as under. If an item has been bought for, say, Rs. 50, and has been sold for, say, Rs. 70, a profit of Rs. 20 has been made per unit bought and sold. By then, the next lot of purchases would have become costlier, and, as an extreme case, let the unit cost at the subsequent purchases be Rs. 70. Then the profit made earlier is annulled; and one has to wait for making some profit t by sale of this next might be less - due to reluctance or resistance from customers) but the trader continues to be under the obligation to pay taxes on the profit made earlier, though subsequently nullified - not because the profit made was fictitious but because the pieces have been rising. Besides taxes due, the business may also have to face obligations to pay dividends since profit has been made on the individual item between its purchase in and sale out. In the generalized case, both the size of the inventory and also the amount and direction of price changes - affect the quantum and direction of inventory profit.
(b) Weighted Average Cost Method is said to moderate this lacuna in the FIFO method. The weighted average cost is taken for each relevant occasion of valuation, say, monthly, if inventory value updations are intended to be done monthly. Summing up the product of quantity and rate for the relevant quantity in each lot (of purchase) as may be appropriate for the intended computation and dividing this total sum of cost by the sum of the respective quantities, the weighted average cost appropriate to the occasion of inventory valuation is obtained. This computational procedure can successively go with each occasion of inventory valuation updation including till the closing inventory. The impact of rising prices could be abated to some extent by this method, where, except for weighted averaging of unit costs as appropriate, the assumption regarding picking up of inventory to be moved out as per order of receipt (as in FIFO) is continued with.
(c) LIFO Method with LIFO standing for LAST IN FIRST OUT, considers the latest among the lots of purchases of material as qualified to be moved out first for processing or sale. In times of rising prices, high unit cost items would, by this method, get included in the cost of goods sold, before lower unit cost items would also get to be moved out. This assumption of LIFO is supposed to eliminate the incidence of inventory profits, in most part, if not altogether. Accordingly, though it is a tax-saving device to some extent, it does not record cost expiration. Also this assumption patently is unacceptable in times of falling prices. On close scrutiny, it is obvious that in times of larger volumes of sales, cost of purchases done earlier would also enter the cost of goods sold, and, this would affect profit realizable.
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