LIFO and FIFO- Which Inventory Method is Better?
Just as inventory management varies from each industry, businesses utilize different accounting methods to optimize income taxes, financial accounting, and cash flow.
The first in, first out and last in, first out methods use unique inventory control to calculate the total cost of goods. However, each technique is applicable to specific scenarios and reporting standards, which should be assessed before implementation.
How Does FIFO Work?
First in, first out (FIFO) is an inventory valuation method that assumes the products purchased first are the first inventory sold. In other words, goods leave a business in the same order they entered.
Since older inventory is sold first, this tactic is ideal for inflation periods, or when businesses raise their prices. Prioritizing the sales of older items also lowers the cost of goods sold (COGS) and boosts profits, as older items are typically cheaper than future goods.
The FIFO method is used to calculate the COGS by multiplying the cost of goods by the sales during the same period. The total cost of stock purchases is then used to calculate the ending inventory, and since FIFO assumes the oldest items are sold, the ending inventory is comprised of the newest products.
To determine their ending inventory and COGS within a quarter, they first have to outline their beginning inventory and purchases.
For example, an electronics retailer has a beginning inventory of 1,700 computers at the start of the fiscal year and purchases an additional 500 computers monthly. The store sold a total of 2,000 computers in the quarter, even though the unit cost rose from $168 to $174 in increments of $3 over the three months.
Beginning Inventory- 1,700 computers
Quarter Purchases- 1,500 computers (500 computers x 3 Months)
Quarter Sales- 2,000 computers
Ending Inventory- 1,200 computers (1,700 + 1,500 2,000)
By breaking down the quarterly inventory costs and sales, the COGS can be calculated-
Beginning Inventory Value- 1,700 computers x $168 = $285,600
January Purchases- 500 computers x $168 = $84,000
February Purchases- 500 computers x $171 = $85,500
These values are added up to show the FIFO quarterly COGS of $455,100. This calculation omits the purchases made in March based on the assumption that the latest products are still in stock. The remaining inventory can then be calculated to determine the ending inventory value-
Ending Inventory Value- 500 computers x $174 = $87,000
How Does LIFO Work?
The last in, first out (LIFO) method assumes that the latest goods to join the inventory are the first units sold. In other words, products leave in the reverse order in which they arrived. This cost method is not as common as the FIFO method, but it is an excellent tool to optimize the COGS and ending inventory.
The LIFO method is mostly used during inflation, as goods sold first are typically the most expensive, increasing COGS and reducing profits. This requires companies using LIFO to report a low net income on financial statements, minimizing their tax liability.
Calculating LIFO accounting is similar to FIFO, with the exception of valuating the old inventory. Instead of incorporating the oldest products into the COGS calculation, FIFO focuses on the latest added products. The sales within a specific time frame are multiplied by the price of each unit. The price of the oldest stock, or the first good purchased, determines the ending inventory value.
For example, a sporting goods distributor begins their quarter with 175 baseballs with a market value of $1,225, or $7 each. The retailer purchases an additional 80 baseballs each month, from January to March, for a total of 240 by the end of the quarter. By the end of March, they sold 270 baseballs as the market price rose monthly by $1, from $7 to $9.
Beginning Inventory- 175 baseballs
Quarter Purchases- 240 baseballs (80 baseballs x 3 months)
Quarter Sales- 270 baseballs
Ending Inventory- 145 baseballs (175 + 240 270)
After the quarterly inventory costs and sales are broken down, the COGS can be calculated using LIFO-
March Purchases- 80 baseballs x $9 = $720
February Purchases- 80 baseballs x $8 = $640
These two expenses are summed up to find the COGS of $1360. The LIFO strategy assumes that the January purchases, or first inventory added, remain. Therefore, the beginning and first items purchased are added to find the ending inventory value.
Beginning Inventory Value- 175 baseballs x $7 = $1,225
January Purchases- 80 baseballs x $7= $560
Ending Inventory Value- $1,225 + $560 = $1,785
LIFO vs. FIFO
While some companies try to balance their inventory management by using both valuation methods, others should understand how each strategy affects stock optimization and cost accounting.
First, business owners must recognize that the higher the inventory cost, the lower the taxes, and vice versa. Therefore, they must assess how the accounting methods change the cost of goods-
- If the organization's inventory costs are increasing or are projected to rise, LIFO is ideal as it bases COGS on the latest purchases, which are typically more expensive than older products.
- When stock costs are decreasing, FIFO accounting may be better as it prioritizes selling the oldest inventory first.
- FIFO is ideal for gaining a more accurate insight on total inventory cost because it assumes the older, less expensive items are sold.
Generally speaking, most financial advisors favor FIFO as it appraises inventory costs less and promotes gross profits. However, there are some scenarios where the LIFO method may be better. Financial managers should understand each tactic's advantages and disadvantages to optimize financial reporting during various accounting periods-
- Businesses Experiencing Rising Costs
- Businesses That Use LIFO
- Businesses That Experience Stock Write-Offs During Inflation
- Seasonal Companies
The LIFO and FIFO inventory valuation methods have distinct inventory elements and accounting principles they focus on to determine the total COGS and ending inventory. This makes it especially crucial for businesses to consider their type of inventory and industry before choosing their preferred accounting method.
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