“Inventory is money sitting on shelves” – Philip Fisher
Efficient inventory accounting is crucial for streamlining logistics, reducing tax liability, and boosting profitability. That’s why manufacturing and trading enterprises emphasize calculating ‘ending inventory’ and cost of goods sold (COGS) during an accounting period.
Not sure how to assess raw materials, finished goods, and production consumables? In this article, discover the what, why, and how of two standard inventory accounting methods: last-in, first-out (LIFO) and first-in, first-out (FIFO).
Read More: 8 Best Inventory Management Software in 2023
What are LIFO and FIFO?
LIFO and FIFO are two common inventory valuation methods for assessing inventory and calculating COGS. Organizations use these inventory accounting methods to report inventory value on balance sheets and inventory expenses on the profit and loss (P&L) statements. LIFO and FIFO comply with generally accepted accounting principles (GAAP) but follow different assumptions.
LIFO stands for last-in, first-out. The LIFO method assumes that the latest items in the stock are the first to sell. As a result, the older inventory remains unsold for an extended period. Selling new stock first helps companies to report higher inventory costs and lower profits.
FIFO stands for first-in, first-out. The FIFO method works on the principle that an organization sells the oldest inventory first. It’s much simpler to track inventory, cash flow, and profits with FIFO because of its straightforward approach.
What are FIFO and LIFO in accounting?
FIFO and LIFO are inventory cost accounting methods for calculating the value of goods or inventory companies sell during a period. These accounting methods determine how organizations represent their inventory of raw materials, produced goods, and profits in financial reports. As a business leader, you must analyze both inventory management methods to understand which is ideal for calculating your company’s inventory.
Significance of inventory management in business operations
Inventory is the most valuable asset for business owners in retail, manufacturing, and wholesale. Inventory management plays a key role in how they optimize profits or track products throughout the production lifecycle. They use inventory management software to source raw materials, manage stock levels, and forecast demand.
Simply put, efficient inventory management helps you boost cash flow, maximize profits, gain business intelligence, and quickly respond to customer needs.
- Profit and loss: The income section of a profit and loss report reflects a company’s inventory sales revenue, whereas unsold inventory shows up as assets on the balance sheet. In these reports, business owners may not see the indirect costs of storage, labor, and human resources. Moreover, poor inventory management practices like late deliveries, insufficient stock levels, and overstocking result in revenue loss.
- Business intelligence: Enterprises combining inventory management software with point of sale (POS) billing solutions can quickly identify top-selling products. These sales analysis insights allow them to forecast demand accurately, optimize stock levels, and make profits.
- Inventory control and cash flow: Buying inventory items results in expenses that directly impact your company’s cash balance. As a result, the company’s cash flow statement shows reduced cash or cash equivalents. Similarly, selling these inventory items decreases stock levels and boosts positive cash flow. Holding onto inventory beyond current sales demand drains finances and results in surplus inventory. That’s why organizations use effective inventory sourcing and management to improve cash flow analysis results.
- Customer needs: Out-of-stock items frustrate customers and lead to missed sales. An intelligent inventory tracking system helps businesses maintain optimal stock levels and improve customer experience.
Two popular inventory costing methods: LIFO and FIFO
LIFO and FIFO methods assume that changing raw material, overhead, and labor costs lead to fluctuating inventory costs. Consequently, the cost of goods isn’t the same every day. That’s why using either method is essential to track inventory movement and record appropriate costs. The LIFO method is suitable for enterprises selling non-perishable goods, whereas FIFO suits companies selling products that may perish or become obsolete.
1. LIFO (last-in, first-out): A detailed explanation
LIFO is an inventory management approach that calculates the inventory value based on the assumption that the latest items or finished goods are the first to sell. As a result, the older stock items sit idle for an extended period before a company sells them. In LIFO, the inventory value equals the total cost of the latest purchases. Also, the inventory cost of stocked items equals the value of goods purchased initially.
The LIFO method enables organizations to report higher COGS, undervalue net income, and show less profits. Their income tax burden decreases as a result. This method is ideal for enterprises dealing with non-perishable goods such as oil, gasoline, and automobiles.
1.1 How does LIFO work?
The LIFO inventory accounting method works by matching COGS with the cost of recently purchased inventory. Accountants and supply chain management professionals calculate the LIFO value by multiplying the number of the latest inventory items with the current inventory cost.
Here’s a step-by-step breakdown of how the LIFO method works:
- Inventory procurement involves purchasing or producing raw materials or finished goods that a company records as the latest additions to its stock.
- Cost of goods sold is the value of inventory that an organization sells from the recently acquired stock. LIFO enables companies to report higher COGS because it considers the latest, high-cost inventory items to sell first.
- Ending inventory refers to the oldest items that sit idle in the stock. The LIFO method results in a lower ‘ending inventory’ value than the current market value because of its emphasis on the latest inventory prices.
Enterprises use LIFO during inflation to report lower net income, higher COGS, and reduced taxes. However, this method undervalues the old stock and therefore doesn’t provide an accurate overview of a company’s inventory. Moreover, specific accounting standards may not accept LIFO for financial reporting purposes.
1.2 How do you calculate LIFO?
Companies use LIFO to calculate COGS based on the latest inventory prices. This inventory accounting method enables them to report higher COGS and lower net income. The LIFO accounting formula is:
Cost of goods sold = (the number of latest inventory items x their value) + (remaining inventory items from second purchase x their value)
Organizations typically follow the steps below to calculate the COGS and value of ending inventory.
- Record stock purchase and sales transactions, besides the price and quantity of products you buy and sell.
- Calculate the latest inventory cost for calculating COGS during an accounting period.
- Multiply the item quantity sold by the unit price of the newest inventory items to find the COGS.
- Calculate the ‘ending inventory’ value by multiplying the older stock items with unit prices.
Organizations also match the total COGS available for sale by summing the costs of all inventory purchases during a period. While these steps look simple, LIFO involves complex calculations since you must exclude the earliest inventory purchases.
1.3 Examples of LIFO
Let’s take the example of a small business owner John, selling laptops. Below is their inventory for the first two fiscal quarters of 2023.
John has sourced 530 laptops but sold only 300 till the end of the second fiscal quarter. Since John uses the LIFO method, he’ll calculate the COGS based on the price he paid for each laptop in June.
COGS = 300 laptops x $500 each = $1,50,000
The LIFO method forces John to show reduced profits and consider the earlier sourced laptops as inventory. However, the reduced taxable income offers him a tax break.
2. FIFO (first-in, first-out): A detailed explanation
First-in, first-out, or FIFO is a cost-flow inventory valuation method that assumes business owners first sell the goods they manufacture, procure, or produce. This method provides a comprehensive ending inventory overview on the balance sheet. It enables enterprises to show lower inventory costs and higher profits when product prices increase. However, organizations using FIFO report higher pretax earnings, increasing their tax liabilities.
Inventory calculation in FIFO is straightforward. Businesses selling perishable products like food, healthcare, and grocery items opt for the LIFO method.
2.1 How does FIFO work?
The FIFO inventory accounting method matches COGS with a business’s earliest inventory cost. Accountants multiply the earliest inventory items with the unit cost to calculate the FIFO value. Below is a step-by-step breakdown of how the FIFO method works.
- Inventory valuation considers the unit cost of the oldest stock a business procures. Businesses using the FIFO method sell inventory in the exact order they produce or procure goods.
- Ending inventory calculation includes the latest inventory items at current market prices.
- COGS equals the prices of goods a company sells during a period based on the actual inventory acquisition order.
FIFO offers realistic matching since it matches COGS with the prices of the earliest inventory items. Organizations using this method enjoy lower taxes when prices fall and higher tax liabilities during inflation.
2.2 How do you calculate FIFO?
The FIFO method calculates inventory value and COGS based on the prices of the first inventory items organizations procure. You can calculate FIFO using the formula below.
Cost of goods sold = (the number of old inventory items x their value) + (remaining new inventory items from recent purchases x their value)
Follow the steps below to calculate the LIFO value:
- Record inventory purchases along with cost per unit, total quantity, and the total purchase cost during an accounting period.
- Gather sales transaction data for all items you sell during the period.
- Calculate COGS by multiplying the total number of products you sell with the unit cost of the oldest items you sourced.
- Find the ending inventory value by multiplying the latest items at current market prices.
Businesses using the FIFO method must maintain historical purchase and sales transactions because the total COGS equals the value of the latest items and old goods sold at respective prices.
2.3 Examples of FIFO
Let’s go back to the example of John selling laptops. Below is the inventory he sourced during the first two fiscal quarters in 2023.
He has procured 600 laptops but sold only 300 by the beginning of the third quarter. Since John is calculating the FIFO method, he’ll calculate COGS based on the unit price of the earliest inventory items.
COGS = 300 laptops x $200 = $60,000
The difference between the cost of inventory calculated using LIFO and FIFO is $90,000. This difference is known as the LIFO reserve — a contra-inventory account that shows the discrepancy between FIFO and LIFO calculations. Organizations use the LIFO reserve account to calculate the taxable income they deferred using the LIFO method.
LIFO and FIFO: Key differences
The LIFO and FIFO methods assume different principles for inventory tracking and COGS calculation, leading businesses to experience differences in taxes, financial reporting, and inventory valuation.
1. Inventory valuation
The LIFO method considers a company’s most recently purchased inventory for COGS calculation. Since it doesn’t include old stock, the total inventory valuation is much lower than the entire inventory. Moreover, you won’t get an accurate inventory value because of excluding older stock items. Most enterprise businesses can’t use LIFO because they can’t let the oldest inventory sit idle.
On the other hand, the FIFO method assumes that older inventory items are the first to sell. It also counts the recent purchases at their current market prices. As a result, this method offers an accurate ending inventory value. Most companies use FIFO to ensure the COGS matches their production schedule.
2. Income tax
Organizations often use the LIFO method to show a higher cost of goods sold during rising product prices. The resulting expense increase lets them minimize inventory value and report lower taxable net income. Consequently, their tax liability decreases.
In contrast, the FIFO inventory method calculates COGS based on the assumption that the older items will sell first. The inventory still has the recent purchases at higher prices procured at high prices. As a result, an organization ends up showing higher taxable income in financial statements.
3. Financial reporting
Since the LIFO inventory method only accounts for recent purchases, organizations using it don’t require historical inventory transactions. However, they must use inventory management solutions for tracking the early stock items they report in bookkeeping. Enterprises using the FIFO method must maintain historical inventory data to report the total cost of goods sold accurately. They typically use accounting software for automating bookkeeping requirements.
US-based enterprises enjoy greater flexibility in opting for LIFO or FIFO. However, organizations outside the US can’t use the LIFO method while following the International Financial Reporting Standards (IFRS). Indian Accounting Standards (Ind AS) also align with the IFRS guidelines and require Indian companies to use FIFO or weighted average cost for inventory valuation.
4. Effect of inflation
Enterprises using the LIFO method during an inflationary period report higher COGS since new inventory items are more expensive. Consequently, they have reduced profits, which results in them paying less in taxes. Organizations opting for FIFO calculate COGS based on older inventories, leaving the latest stock on the balance sheet. As a result, they end up with higher net income and tax liability.
Inventory valuation is based on the latest inventory purchases.
The oldest stock determines the value of inventory.
Products are sold at current market prices.
Unsold inventory value is calculated based on current market prices.
Multiply the old inventory cost by the number of goods sold.
Multiply the latest inventory cost by the number of items sold.
Effect of inflation
Skyrocketing product prices help companies report increased COGS and lower profits.
Increasing prices decrease the COGS as FIFO considers the oldest items to sell first. The result is increased profit and net income.
Effect of deflation
LIFO results in higher unsold inventory value and profits during a deflationary period.
Using FIFO during deflation results in lower profit and unsold inventory value.
IFRS prohibits organizations from using LIFO outside the US.
Both IFRS and GAAP allow the use of FIFO across the world.
Income and tax liability
LIFO lowers income and reduces tax liabilities when product prices rise.
FIFO shows higher profits and increases income tax burdens during price rises.
The LIFO method doesn’t attract investors since it shows lower net income.
The FIFO method attracts investors because it accurately represents the inventory value.
LIFO and FIFO: Advantages and disadvantages
While organizations can use LIFO and FIFO methods depending on their locations, both approaches are more suitable for some businesses than others. Consider weighing the pros and cons below to evaluate what’s ideal for your business.
1. Advantages of using the LIFO method
Enterprises using LIFO for inventory valuation enjoy tax benefits during an inflationary period, report realistic cost-flow matching, and meet industry standards for stocking perishable goods.
- Tax benefits: The LIFO method enables companies to report reduced profits as it calculates COGS based on the latest inventory prices. Consequently, businesses can show lower gross margins, which reduce tax liabilities and increase short-term cash flow during inflation.
- Best for perishable goods: Industries selling perishable goods with limited shelf life use the LIFO to sell the latest inventory items first. This COGS calculation based on the latest prices lets them match increasing inventory acquisition costs with sales revenue.
- Cost control: Enterprises offering profit-based employee bonuses use LIFO to report lower profits and control expenses during an inflationary period.
2. Disadvantages of using the LIFO method
Organizations reporting inventory value using LIFO struggle with credibility concerns, inventory undervaluations, and high taxes during stable economic conditions.
- Inventory undervaluation: Businesses using the LIFO method report less inventory value on their balance sheets than the actual amount. This inventory undervaluation can cause owners to misinterpret working capital, equity, and financial health.
- Tax challenges: While LIFO may be beneficial during inflation, organizations using this method end up showing higher taxable income during a stable economic period.
- Credibility issues: Enterprises using LIFO to manipulate earnings and profits may face questions from stakeholders and investors. As a result, companies may not be able to persuade investors.
- Increased inventory costs: Since LIFO calculates COGS based on recent stock, it considers older inventory items still in stock. Carrying the aged inventory for an extended period increases depreciation and carrying costs.
3. Advantages of using the FIFO method
Besides accurately reflecting the physical inventory flow, the FIFO method enables businesses to lower taxes during stable economic environments and improve financial ratios.
- Cost and revenue matching: Using the FIFO method enables companies to match sales revenue with inventory costs. As a result, organizations are better able to depict their financial health. Moreover, FIFO calculations provide accurate ‘ending inventory’ value by considering current market prices.
- Accurate reporting: Enterprises using FIFO can also match sales prices and inventory costs better when product prices decrease or remain stable. The result is precise profitability and cost recognition reporting. Business owners use FIFO during deflation to lower taxable income and reduce tax liabilities.
- Positive financial ratios: Companies using FIFO typically report higher asset values and positive financial ratios. That’s why investors are more likely to invest in companies using FIFO for inventory accounting.
- Improved inventory turnover: Many organizations use FIFO to manage inventory efficiently and prevent inventory holding costs from going up in the future.
4. Disadvantages of using the FIFO method
Despite offering tax relief during deflation, FIFO isn’t beneficial for lowering taxes during an inflationary period. Moreover, this method requires complex bookkeeping and doesn’t help businesses match current costs with revenues.
- Higher tax liabilities: FIFO isn’t a suitable inventory valuation method for inflation or hyperinflation. Since this method matches the lower cost of older items with higher revenues, businesses report higher net income and gross profit. As a result, their taxable income increases.
- Complex bookkeeping: Since FIFO matches prior stock purchases with recent sales, organizations must maintain historical transactions. The result is a resource-intensive bookkeeping process.
Challenges and limitations of LIFO and FIFO
Using LIFO presents organizations with multiple limitations. Below are some significant inventory and financial analysis challenges they experience with this inventory accounting method.
- Reduced earnings: The LIFO method compels an organization to report reduced earnings during inflationary periods. As a result, investors may not have an accurate picture of the company’s financial situation.
- Inventory understatement: LIFO understates the ‘ending inventory’ value as it considers the price of older stocks. As a result, the working capital looks worse than it is in reality.
- LIFO liquidation: Since LIFO inflates the reported earnings, companies using this method make higher tax payments. Some organizations may also start buying products in large quantities to avoid this problem, which can result in poor buying habits.
On the other hand, FIFO calculates COGS utilizing the price of older stock items. That’s why it leaves the recently procured expensive items on the balance sheet. Consequently, organizations using this method can’t match COGS with the actual cost of materials when preparing financial statements. All these ultimately result in increased net income and inflated profits during inflationary periods.
How to implement LIFO or FIFO in business?
Understanding which inventory accounting method suits you is critical to streamlining inventory operations and managing stocks better. While the LIFO method helps companies report lower net income and pay less taxes, FIFO increases reported earnings yet provides a comprehensive view of the inventory.
Manufacturing businesses dealing with perishable items or products subject to obsolescence use the FIFO method for inventory accounting. LIFO is the most commonly used technique for calculating the inventory of non-perishable items.
Countries following IFRS rules, including India, are prohibited from using the LIFO method. However, organizations in the United States of America can follow LIFO under the GAAP principles.
Which method is better: FIFO or LIFO?
Companies may prefer LIFO or FIFO depending on their financial circumstances and business objectives. Accounting experts recommend organizations to use FIFO during inflation and LIFO accounting during deflationary periods. Consider the factors below before opting for either of these methods.
- Location and regulatory guidelines: Since most countries except the US don’t allow organizations to use LIFO, you must consider the geographic location of your business entity and check the rules you should follow.
- Financial objective: The financial goal of your organization plays a crucial role in deciding the method you choose. For example, LIFO can reduce taxes when product prices rise, whereas FIFO provides an accurate overview of inventory and profitability.
- Inventory movement: Businesses selling perishable products like food are better off with the FIFO method, whereas organizations dealing with non-perishable items like oil prefer LIFO for easy inventory tracking. Consider choosing the method that makes inventory management effortless for you.
How to select the right method for Your business?
Choosing the correct inventory accounting method is extremely important as it significantly impacts your company’s income statements, balance sheets, and financial position. Follow the steps below to weigh your options before choosing FIFO or LIFO.
- Know the options: Start by understanding the advantages, disadvantages, tax implications, and financial impact of different inventory accounting methods like LIFO, FIFO, and average cost.
- Learn the industry practices: Some industries may have established regulations about following LIFO or FIFO. These practices can significantly influence your choice of inventory accounting method.
- Market conditions: You should also consider the current economic environment before choosing an inventory accounting method. For example, LIFO offers tax benefits during inflation or hyperinflation. On the other hand, FIFO reduces tax liabilities during deflation.
- Operational requirements: Organizations must consider their inventory management and accounting software capabilities before choosing LIFO or FIFO. For example, FIFO requires businesses to maintain older inventory transactions for ease of COGS calculation, whereas FIFO doesn’t.
- Consult with professionals: Consider speaking to financial advisors to understand each method’s legal and tax implications.
LIFO and FIFO alternatives
When organizations can’t use LIFO or FIFO, they opt for another generally accepted inventory valuation method called weighted average costing (WAC). This method considers purchasing prices of goods for calculating inventory valuation. It doesn’t matter when or at what price you bought those products.
This inventory costing method is suitable when businesses can’t accurately determine an individual item’s cost. For example, it may be challenging to decide on the price of each product amidst fluctuating inventory prices. That’s when you can use the WAC method for inventory valuation. WAC generally returns a valuation between LIFO and FIFO.
Businesses divide the total COGS by the total number of inventory items available for sale to calculate the weighted average cost.
Is LIFO allowed under GAAP?
The Generally Accepted Accounting Principles (GAAP) allow organizations to choose LIFO, FIFO, or the weighted average cost method. However, companies following IFRS standards must only use FIFO for inventory valuation reporting. The Accounting Standards for Private Enterprises (ASPE) also refrains enterprises from using LIFO. The primary reason for this prohibition is that the LIFO method doesn’t provide accurate income statement matching.
Inventory valuation is crucial in determining an organization’s net income, tax liabilities, profitability, and financial reporting. Organizations can only convey their financial position to investors and stakeholders using a suitable method like LIFO, FIFO, or WAC. While each method has pros and cons, businesses selling perishable items prefer FIFO, whereas LIFO suits non-perishable products. Depending on your business location and the market conditions, each method has unique tax and legal implications. Consider speaking to finance professionals to fully understand these implications and find the one that suits you best.
LIFO stands for last-in, first-out, and FIFO for first-in, first-out in inventory management.
LIFO shows lower net income and profit margin when the inventory cost rises, at least on paper. In similar situations, FIFO results in higher profit margins.
Businesses using LIFO during inflation report less earnings and thus decrease income tax liabilities. On the contrary, organizations reporting COGS using FIFO will show higher net profit and pay more taxes.
Indian companies can’t opt for LIFO methods, as stated under the Indian Accounting Standards. Businesses in the United States can switch between LIFO and FIFO methods after obtaining the necessary permission from the regulatory bodies.
Industries dealing with perishable products like food and grocery prefer to use the FIFO method. Businesses selling non-perishable items like oil and automobiles use the LIFO method to reduce tax liabilities by selling recent inventories first.
The LIFO method results in lower earnings and reduced tax liabilities during inflation. It returns higher gross margins and increases taxable income during deflation. Businesses using FIFO experience increased profits and pay higher taxes during inflationary periods. However, using FIFO during deflation reduces the tax burden because of lower yields.
LIFO uses the latest inventory prices for COGS calculation. As a result, the ‘ending inventory’ value appears less than the actual value. On the other hand, FIFO calculates COGS based on the oldest inventory prices, offering an accurate overview of a company’s finances.
Using LIFO results in higher COGS and lower net income. On the contrary, FIFO returns lower COGS and higher net income.
Countries following the IFRS guidelines don’t allow businesses to use the LIFO method. However, US-based companies can use it under the GAAP. Businesses worldwide can use the FIFO method.
No, an organization must follow LIFO or FIFO consistently for inventory valuation and financial reporting purposes.
Companies using LIFO report a lower ending inventory. As a result, they show lower financial ratios. On the other hand, businesses using FIFO report higher ratios as they show higher amounts of inventory in current assets.
Automobile, gasoline, oil, and jewelry companies use the LIFO method, whereas FIFO is preferable among companies selling dairy, horticulture, healthcare, and food products.
A company should consider multiple factors like business location, industry practices, flow of inventory, market conditions, and operational requirements before choosing LIFO or FIFO for inventory management.