- 📅 February 25, 2023 📝 Last updated on March 19th, 2023 🕒 13 minutes Read time
Any business dealing with products must understand the significance of inventory management. Choosing the right method to value inventory can impact several aspects of a business, including income, logistics, taxes, and profitability. The two primary inventory management methods are the first in, first out (FIFO), and last in, first out (LIFO) approaches.
The FIFO approach is geared towards reducing losses from expired or outdated products. On the other hand, LIFO is more suitable for non-perishable items and computes the cost of goods (COGS) sold using current prices. Knowing the differences between these approaches is crucial for selecting the most suitable inventory valuation approach for your business. In the following paragraphs, we will explore how both FIFO and LIFO work and their relative pros and cons.
First-In, First-Out (FIFO)
FIFO values the remaining inventory at the latest price and assumes the first items purchased are the first sold, meaning older inventory is used up first. For example, if a manufacturer produces 500 units on Monday for $5 each and another 500 on Tuesday for $6 each, selling 500 units on Wednesday would result in a COGS of $5 per unit and an ending inventory valued at $6 per unit. This method is useful when inventory costs are increasing. However, it’s crucial to consider business needs and goals when selecting an inventory management method.
To effectively utilize the FIFO inventory method and gauge its effects on your enterprise, it is crucial to know how to determine the COGS via this method. Firstly, find the expense of your earliest stock and multiply it by the number of products sold. This delivers the costs related to selling inventory via FIFO. Alternatively, calculate the ending inventory by subtracting the COGS from the goods available for sale.
Let’s say, for example, that Torch Co. procured two groups of inventory in the initial year of operations. The initial batch comprised 6,000 items at $1.25 each, and the second batch comprised 12,000 items at $1.75 each. Torch Co. sold 14,000 items, with 4,000 items sold following the first procurement and 10,000 following the second procurement. In a periodic inventory system, to calculate the ending inventory and COGS using the FIFO method, you must first calculate the goods available for sale.
Beginning inventory ($0)
Batch 1 purchases (6,000 units @ $1.25 each): $7,500
Batch 2 purchases (12,000 units @ $1.75 each): $21,000)
= Goods available for sale ($28,500)
It is evident that 14,000 units were sold after the acquisition of both batches. Therefore, we can calculate the ending inventory by subtracting the COGS from the cost of goods available for sale.
Calculate the COGS using periodic FIFO:
COGS from Batch 1 (6,000 units @ $1.25 each): $7,500)
COGS from Batch 2 (8,000 units @ $1.75 each: $14,000)
= Total COGS ($21,500)
Now, calculate the ending inventory:
Goods available for sale ($28,500)
– COGS ($21,500)
= Ending inventory ($7,000)
Whether FIFO is the right inventory management system for any business will depend on its effects on these key metrics:
While FIFO provides a precise representation of ending inventory, it can increase net income and tax liability. Despite this, businesses may prefer it to impress investors, as it can result in a higher value for ending inventory. However, this can negatively affect the bottom line due to higher tax liabilities. Accurate financial reporting and sound inventory management practices should be prioritized over short-term gains. Evaluating the pros and cons of inventory methods and considering specific business needs and goals can lead to informed decisions and better outcomes.
FIFO offers advantages like lower cost per unit, leading to higher profits, but also higher taxes. It assumes the oldest inventory sold first, reflecting market prices for ending inventory value. Good for companies using old inventory in production, reflecting their schedule, and is preferred.
Using the FIFO method, older and cheaper inventory is used first, while newer and more expensive inventory is recorded on the balance sheet. This results in an increase in net income due to the lower COGS, but can also lead to a higher tax liability for the company. This approach is especially useful in a rising-price environment, as it accurately values the COGS.
FIFO records sales using current market prices, reflecting better value for ending inventory as older items have been used. Businesses preferring higher pretax earnings with a lower cost per unit choose this, but it has drawbacks. Choosing the best inventory method requires evaluating its pros and cons to suit specific business needs.
Choosing FIFO requires consideration for extended inventory periods or inactivity. Retrieving historical records for the COGS may be necessary, but automation is available. Transactions have a higher turnover rate than LIFO. In times of rising prices, it can undervalue inventory and assumes the first inventory sold first. Still a viable option with accurate value on the balance sheet, optimizing profits, taxes, and financial statements with the right inventory method.
When it comes to inventory management, FIFO, vs. LIFO, taxes may be higher because it assumes that newer and more expensive items are sold first, leaving older and cheaper items in stock. This, in turn, leads to higher levels of inventory, which can increase taxes.
On the other hand, using the oldest and cheaper items in the COGS can lead to lower expenses, higher net income, and higher tax liability.
Managing inventory requires using the same method for both financial and tax reporting, per IRS regulations. Businesses should evaluate their nature, inventory, and goals to determine the best method. By considering cost, complexity, and accuracy and understanding the pros and cons, businesses can make informed decisions for long-term benefits. Choosing a suitable method can avoid tax issues and improve inventory management and financial reporting.
In the case of periodic FIFO used for calculating the COGS or ending inventory, the timing of when the inventory is sold is not a factor.
The periodic FIFO inventory method assumes that the first items purchased are the first sold, assigning their cost to goods sold or ending inventory. Although it simplifies inventory management, it’s important to consider other factors when selecting a method.
Minimizing waste by using the oldest inventory first is a primary objective of inventory management. This approach prevents losses due to spoilage, expiration, or obsolescence, and optimizes resource use. However, it’s crucial to balance this goal with factors such as customer demand, production schedules, and supply chain logistics. A comprehensive strategy that considers multiple factors can optimize inventory usage for the best outcomes.
FIFO helps prevent obsolete or expired inventory and assumes the oldest inventory is sold first, reducing tax liability and optimizing profits. It also improves financial reporting by facilitating accurate inventory tracking. By using this method, businesses can minimize their inventory waste, track inventory levels more accurately, and improve their financial performance.
Last-In, First-Out (LIFO)
LIFO is the opposite of FIFO, using current prices to calculate the COGS, resulting in a higher COGS if prices increase. This reduces profits and tax liability and is suitable for nonperishable commodities when allowed.
LIFO is not a good indicator of ending inventory value because leftover inventory can be old and obsolete, resulting in undervaluation. LIFO can also lead to lower net income due to higher COGS.
Under LIFO, the most recent inventory is assumed to be sold first, leaving older inventory at the end of the period. For example, a bakery assigns $1.25 per loaf to COGS for 200 loaves sold on Wednesday, leaving the remaining $1 loaves for inventory value calculation.
LIFO can be useful for rising inventory costs but may undervalue inventory and result in lower net income. Businesses must evaluate LIFO’s pros and cons to choosing the most appropriate inventory valuation method for their operations.
Both LIFO and FIFO require determining the cost of inventory items sold but differ in the selection of inventory items for the COGS calculation. LIFO uses the most recent inventory items first, while FIFO uses the oldest.
For example, a computer manufacturing company that uses LIFO would use the most recent and expensive cost of a component to calculate the COGS.
LIFO can lower tax liability by increasing the COGS, but may not accurately reflect inventory value or production process. Evaluating the pros and cons of LIFO helps businesses choose the appropriate inventory valuation method. This ensures accurate inventory value, optimized financial performance, and minimized tax liability.
To calculate the COGS using LIFO, start by determining the cost of the newest inventory first. In the case of Torch Co., the cost of Batch 2 inventory is higher, so we want to use up that inventory first.
Batch 2: 12,000 units x $1.75 = $21,000
Batch 1: 2,000 units x $1.25 = $2,500
Total COGS using LIFO: $23,500
The LIFO ending inventory calculation involves subtracting the COGS from the total cost of goods available for sale.
Total cost of goods available for sale: $28,500
Ending inventory using LIFO: $5,000
Using LIFO in Torch Co.’s case resulted in a higher COGS than FIFO, which would lead to lower taxable income and lower taxes. However, the ending inventory value is lower than using FIFO, which could impact the company’s financial statements and borrowing capacity.
To find out if LIFO is a suitable inventory management system for a business, consider how it affects these key metrics:
LIFO may undervalue inventory due to the use of the most recently acquired inventory to value the COGS, resulting in leftover inventory that is old or obsolete. This method is not practical for many companies, particularly those selling perishable goods, where the oldest inventory must be sold first to minimize waste and losses.
For instance, a seafood company would prioritize selling the oldest inventory before it spoils, making LIFO impractical. LIFO may not accurately reflect the logical production process of using the oldest inventory first.
While LIFO can be useful for nonperishable commodities, it may not be suitable for all businesses. Evaluating its pros and cons helps companies choose the appropriate inventory valuation method to accurately reflect inventory value and optimize financial performance.
Impact of Inflation
LIFO uses the most recent inventory to value COGS, selling newer items first and older inventory later. In an inflationary environment, COGS is higher, recording lower profits or net income. This results in a lower tax liability for the company.
LIFO can be useful in certain circumstances, such as when inventory costs are increasing rapidly, as it can help businesses to minimize their tax liability. However, LIFO is not a suitable method for all businesses, especially those that deal with perishable goods, as it may not accurately reflect the value of their inventory or the logical production process of using the oldest inventory first.
Overall, businesses must carefully evaluate the pros and cons of LIFO when deciding which inventory valuation method to use. By doing so, they can ensure that they are accurately reflecting the value of their inventory, optimizing their financial performance, and minimizing their tax liability.
Companies outside of the United States that use International Financial Reporting Standards (IFRS) are not permitted to use the LIFO method. Companies within the U.S. have greater flexibility on the method they may choose and can opt for either LIFO or FIFO.
Though the LIFO inventory method does require a robust inventory management system to track different inventory transactions, LIFO systems often require less demand on historical data as the most recent purchases are sold first. For this reason, companies must be especially mindful of bookkeeping under the LIFO method as once early inventory is booked, it may remain on the books untouched for long periods.
Under the LIFO method, assuming a period of rising prices, the most expensive items in inventory are sold first. This means that the value of inventory is minimized, and the value of COGS is increased, resulting in higher expenses. However, this also means that the taxable net income is lower under the LIFO method, and the resulting tax liability is also lower.
While LIFO can be useful for businesses looking to minimize their tax liability, it may not accurately reflect the value of their inventory or the logical production process of using the oldest inventory first. Additionally, LIFO may not be suitable for businesses that deal with perishable goods, where using the oldest inventory first is crucial to avoid spoilage and losses.
Therefore, businesses must carefully evaluate the pros and cons of LIFO when deciding which inventory valuation method to use. By doing so, they can ensure that they are accurately reflecting the value of their inventory, optimizing their financial performance, and minimizing their tax liability.
The LIFO inventory valuation method is highly dependent on how the prices of goods fluctuate based on the economy. If a company holds inventory for a long time, it may prove advantageous in hedging profits for taxes. LIFO can increase after-tax earnings with a higher COGS. However, the risk of an economic downturn causing the cost of goods to go down can have the opposite effect on all previously purchased inventory.
In conclusion, LIFO can be useful for nonperishable inventory but may not be suitable for businesses dealing with perishable goods or those requiring the use of the oldest inventory first. Businesses must evaluate the pros and cons of LIFO when selecting the appropriate inventory valuation method. This ensures accurate inventory value, optimized financial performance, and minimized tax liability.
LIFO Legal Restrictions
The LIFO reserve is calculated to increase the comparability of LIFO and FIFO firms. However, the trend is moving towards using FIFO due to the physical flow of inventory and the desire for consistency in international accounting standards. It is ultimately up to management to determine the best cost flow assumption for their business, taking into account tax implications and international financial requirements. While some companies may believe that repealing LIFO would lead to a tax increase, many other companies use FIFO with minimal financial impact.
FIFO vs. LIFO Comparison & Contrast
Using LIFO for financial statement comparison across different periods can be challenging due to its reliance on current prices. If prices of goods increase, the COGS is higher, potentially reducing profits and creating tax savings. However, this may not accurately reflect the true financial performance.
On the other hand, in FIFO, vs. LIFO, inventory is more accurate but it may result in higher taxable income and liability. Businesses must consider the industry, tax implications, and operations when choosing between FIFO and LIFO accounting. Companies should consider their unique circumstances and consult with a financial professional to determine which inventory management technique is best for their needs.
If a business chooses to switch from one inventory valuation method to another, it should seek the guidance of a CPA or other financial professional to ensure a smooth transition. The potential impact on financial statements, taxes, and compliance requirements must be considered. Additionally, businesses must follow specific guidelines and requirements, such as notifying the IRS or adjusting financial statements if they change their inventory valuation method. Ultimately, businesses must carefully evaluate and choose the inventory valuation method that best suits their needs and goals.
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FIFO vs. LIFO FAQ
The choice between FIFO and LIFO depends on various factors like tax implications, inventory costs, and business goals. There is no clear answer on which method is better as each has its advantages and disadvantages.
The main difference between FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) is the order in which inventory is sold and removed from stock. In FIFO, the first items purchased are the first to be sold, while in LIFO, the most recently purchased items are sold first.
A company might choose to use LIFO (Last-In-First-Out) instead of FIFO (First-In-First-Out) for accounting purposes because it can result in lower taxable income during periods of rising prices. This is because LIFO assumes that the most recently acquired inventory is sold first, which means that the cost of goods sold will be higher, resulting in lower profits and therefore lower taxes. However, LIFO can also result in lower inventory values on the balance sheet, which can make a company appear less financially stable.