FIFO vs. LIFO

lifo-vs-fifo

FIFO and LIFO are two methods of inventory valuation used for the calculation of the cost of goods sold. FIFO (“First-In, First-Out”) assumes that the oldest products in a company’s inventory have been sold first and goes by those production costs. The LIFO (“Last-In, First-Out”) method assumes that the most recent products in a company’s inventory have been sold first and uses those costs instead.

Here is what we’ll cover:

Definitions:

  • FIFO:

FIFO means First In First Out. The products that are made or purchased at their earliest would be first to be sold, which states that the least expensive product available in the stock will be sold as prices rise up with the passage of time. The companies that use the FIFO method tend to result in a lower cost of goods sold as compared to LIFO and their net income increases over time.

  • LIFO:

LIFO means Last In First Out. The last products that are made or purchased are sold and so goods with higher costs are sold with rising prices that may also result in higher cost of goods sold. In LIFO because of the higher cost of goods sold it also affects the net income to decrease with the passage of time. 

What is the difference between FIFO and LIFO?

A business/company uses these methods in order to assess the inventory costs. Whichever method a company uses to assess has an impact on their profits. The amount of profit generated will then affect their income taxes. So it all depends upon the company for which method it applies.

Inventory refers to the stock that is retained for selling purposes. FIFO and LIFO are taken as assumptions only and not used for recording physical data of inventory. Companies/businesses might be using the FIFO method and also may be selling the first purchased or made item. But we say that in order to calculate the cost of goods sold both of the methods assume that inventory is being sold as per the required order.

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.

How to calculate FIFO and LIFO?

LIFO and FIFO are used as inventory cost methods for calculating the cost of goods sold in actuality.

  • While using the FIFO method calculate the cost of goods sold with the cost of the oldest inventory. Multiply the cost with the cost of inventory sold.
  • When using the LIFO method, calculate the cost of goods sold with the cost of the newest inventory. Multiply the cost with the cost of inventory sold.

The items should be sold in order to be recorded for calculation or else items that are not sold cannot be mentioned to apply any method.

LIFO and FIFO: Impact of Inflation

If inflation was nonexistent, then all three of the inventory valuation methods would produce the same exact results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, our bakery example from earlier would be able to produce all of its bread loaves at $1, and LIFO, FIFO, and average cost would give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period. Assuming that prices are rising, inflation would impact the three inventory valuation methods as follows:

LIFO

When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from lower tax liability.

FIFO

When sales are recorded using the FIFO method, the oldest inventory–that was acquired first–is used up first. FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS. However, the higher net income means the company would have a higher tax liability.

Average Cost

The average cost method produces results that fall somewhere between FIFO and LIFO.

However, please note that if prices are decreasing, the opposite scenarios outlined above play out. In addition, many companies will state that they use the “lower of cost or market” when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value replacement cost instead of LIFO, FIFO, or average cost.

Examples of FIFO and LIFO:

We take an example of a soda company where we will assume the amounts in order to have a better understanding of the two methods FIFO and LIFO.

The new soda company has been in operation for a year now and now wants to evaluate its inventory in accordance to calculate the cost of goods sold.

MonthAmountPrice paid
January200 units$400
February200 units$400
March250 units$425
April250 units$425
May250 units$425
June250 units$450
July250 units$450
August250 units$475
September300 units$475
October300 units$500
November300 units$500
December350 units$525

Total Sodas acquired = 3,150 units

The table shows that prices kept rising with the passage of time in a steady flow. The soda company kept adjusting the prices as per market and earned less profit.

The number of sodas sold for the year were 2,400.

Calculating cost of goods sold with the two methods:

  • FIFO:

Soda Company’s calculation for COGS with FIFO method.

200 units x $400 = $80,000

200 units x $400 = $80,000

200 units x $425 = $85,000

250 units x $425 = $106,250

250 units x $450 = $112,500

300 units x $475 = $142,500

300 units x $475 = $142,500

350 units x $500 = $175,000

350 units x $525 = $183,750

Total cost of goods sold = $1,107,500

  • LIFO:

Soda Company’s calculation for COGS with LIFO method.

400 units x $525 = $210,000

350 units x $500 = $175,000

350 units x $475 = $166,250

300 units x $475 = $142,500

300 units x $450 = $135,000

250 units x $425 = $106,250

250 units x $400 = $100,000

200 units x $400 = $80,000

Total Cost of goods sold = $1,115,000

You can see how for the soda company, the LIFO method may be more attractive than FIFO. This is because the LIFO number reflects a higher inventory cost, meaning less profit and less taxes to pay at tax time. 

The LIFO reserve in this example is $7,500. The LIFO reserve is the amount by which a company’s taxable income has been deferred, as compared to the FIFO method.

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