In the FIFO (First-In, First-Out) calculation process, the costs for your oldest inventory can be calculated and multiplied by the amount of inventory sold, while in the LIFO calculation (Last-in, First-out), the costs of your latest inventory can be determined and multiplied by the amount of inventory sold.
The FIFO (“First-In, First-Out”) method means that the cost of the oldest inventory of a firm is used for the COGS calculations (Cost of Goods Sold). LIFO (“Last-In, First-Out”) refers to the cost of the most recent company’s inventory.
Here’s What We’ll Cover:
- What is FIFO?
- How to calculate FIFO?
- What is LIFO?
- How to calculate LIFO?
- Example of FIFO and LIFO
- Which method of inventory is better FIFO or LIFO?
What is FIFO?
First-In, First-Out (FIFO) method is an asset management and assessment method in which assets that are first produced or acquired are first sold, used, or disposed of.
For tax reasons, FIFO assumes that assets with the oldest costs are included in the cost of the goods sold in the income statement (COGS). The remaining inventory assets match the assets most recently purchased or manufactured.
Although the oldest inventory may not always be the first sold, the FIFO method is not actually linked to the tracking of physical inventory, just inventory totals. However, FIFO makes this assumption in order for the COGS calculation to work.
How to calculate FIFO?
To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.
Please note: If the price paid for the inventory fluctuates during the specific time period you are calculating COGS for, that must be taken into account too.
Let’s use an example. Let’s say 100 items cost a company $50.00 each to produce. For the next batch of 100, the price went up to $55.00.
Now company management wants to see the cost of goods sold. To date, 105 of the company’s products have been purchased. Using the FIFO method, they would look at how much each item cost them to produce. Since only 100 items cost them $50.00, the remaining 5 will have to use the higher $55.00 cost number in order to achieve an accurate total.
What is LIFO?
Last-In, First-Out (LIFO) method is used to account for inventory that records the most recently produced items as sold first. Under LIFO, the cost of the most recent products purchased (or produced) is the first to be expensed as the cost of goods sold (COGS), which means the lower cost of older products will be reported as inventory.
- LIFO is used only in the United States and governed by the generally accepted accounting principles (GAAP).
- Using LIFO typically lowers net income but is tax advantageous when prices are rising.
How to calculate LIFO?
To calculate COGS (Cost of Goods Sold) using the LIFO method, determine the cost of your most recent inventory. Multiply it by the amount of inventory sold.
As with FIFO, if the price to acquire the products in inventory fluctuates during the specific time period you are calculating COGS for, that has to be taken into account.
Example of FIFO and LIFO:
FIFO Method:
Let’s say a business bought shirts on two separate occasions at two different prices during a month:
100 shirts at $10
200 shirts at $20
At the end of the month, the business had sold 50 shirts.
With FIFO, we use the costing from our first transaction when we purchased 100 shirts at $10 each.
So, after selling 50 shirts:
COGS = (50 shirts x $10 FIFO cost) = $500
50 shirts from the first purchase are still left on the shelves, cost $10 each, as well as the remaining 200 shirts from the second purchase at $20 each. So:
Remaining inventory value = (50 shirts x $10 cost) + (200 shirts at $20 cost) = $4,500
LIFO Method:
Using the example above, the LIFO method would use the cost from the latest transaction when 200 shirts were purchased at $20 each.
After selling 50 shirts:
COGS = (50 shirts x $20 LIFO cost) = $1,000
The 100 shirts that we bought in the first purchase are still left at $10 each. We also have 150 shirts from the second purchase at $20 each. So:
Remaining inventory value = (100 shirts at $10 cost) + (150 shirts at $20 cost) = $4,000
Which method of inventory is better FIFO or LIFO?
FIFO is considered the better option as compared to LIFO because it is a more trusted and transparent method to use.
FIFO uses the First in First out method where the items made or purchased first are sold out which is why it is easy and convenient to follow and implement for companies and businesses. Businesses usually sell off the oldest items left in the inventory as they might become obsolete if not sold further. So FIFO follows the same way of going with the natural flow of inventory. If you want to have an accurate figure about your inventory then FIFO is the better method.
In LIFO, it uses the latest inventory to be sold which gives the higher cost of inventory. These costs are higher than the firstly produced and acquired inventory. Higher costs may result in lower taxes with LIFO but it also shows the difference between the two LIFO and FIFO that FIFO represents accurate profits as the older inventory tells actual cost. Using FIFO could show the company’s natural profitability which if it may be high then it would attract the shareholders to invest in that company.
If you want to choose one option from these two inventory methods and costs of inventory are changing then you can look over the following points:
- If inventory costs are rising or are going to rise if you consider them, then go for the LIFO method as the high-cost items will be sold with rising costs. Thus, higher costs will result in lower profits.
- The same is the case vice versa, if the inventory costs are decreasing or are about to decrease, then go for FIFO.
A company applying LIFO will face the problem of not being able to sell the oldest inventory from the stock, hence will also create a problem of not showing current market trends. Manipulation can also be easily done by using the LIFO method.
In the end, FIFO is the better method to go with for giving accurate profit as it assumes older inventory to be sold first.
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