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The first-in, first-out (FIFO) and last-in, first-out (LIFO) inventory methods are two cash flow accounting methods that impact the value of the inventory you record in your books. To record the gains (if any) from the sale of inventory, businesses must track the date and price at which they acquired their existing inventory, as well as the date and price at which that inventory was sold. FIFO and LIFO impact the order in which inventory purchases are accounted for, which may make a difference on your books if the inventory was acquired in separate shipments at different prices.
To stay in business, a company must sell its inventory for more than it costs. That makes it important to keep accurate accounting records so that you know how much profit you are earning from your inventory. FIFO and LIFO accounting are important from both a tax and profitability perspective.
FIFO and LIFO Explained
To understand FIFO and LIFO, we must first understand the inventory equation:
Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold (COGS)
The terms of the equation are expressed in dollars and defined below:
|Beginning Inventory||The dollar value of inventory at the start of a period|
|Net Purchases||The amount spent on purchases less returns for the period|
|COGS||The cost of the goods you sell during a period|
|Ending Inventory||The dollar value of inventory at the end of the period|
Ending inventory, a current asset on the balance sheet, is highly dependent on COGS. FIFO and LIFO are two ways to determine COGS. This in turn impacts the balance sheet and the income statement in terms of the value of inventory, operating expenses, net income and taxes.
FIFO and LIFO make assumptions about the sequence of goods sold during the period. These assumptions are for financial accounting only and may not bear any relationship to the actual physical order in which goods are sold.
To better understand the differences between FIFO and LIFO inventory accounting, we've included a representative case study, as well as outlined the differences between each method in their respective definitions below.
FIFO and LIFO Examples
Your company, Alpha Widget Merchandising, has beginning inventory on the first of the month of 60 widgets costing $12 each, or $720. In addition to the beginning inventory, Alpha undertakes the following purchases over the month.
- Purchase A is 140 widgets on the 5th for $15 each, or $2,100
- Total purchases for the month are $2,100
Simultaneously, Alpha sells its widgets in the following manner:
- Sale X sells 190 widgets on the 14th for $20 each, or $3,800
- Total sales revenue for the month is $3,800
Depending on the manner in which these purchases and sales are accounted for, FIFO and LIFO will give you different values for COGS, ending inventory and gross profit, as illustrated below.
FIFO Inventory Method
FIFO is the standard inventory method used by most businesses. Under FIFO, you assign costs of goods sold starting from the oldest purchases to the newest. Based on the example above:
- 1. Using FIFO, Sale X of 190 widgets requires you to apply earliest costs first. Of the 190 widgets sold, you assign a $12 cost to 60 widgets (from beginning inventory) and $15 to the remaining 130 widgets (from Purchase A), for a total COGS of $2,670.
- 2. After Sale X, your remaining inventory is 10 widgets accounted for at $15 each, or $150.
In summary, under FIFO:
- COGS = $2,670
- Gross Profits = Sales – COGS = $3,800 – $2,670 = $1,130
- Ending Inventory = $150
In our FIFO example, the cost of each widget increased by $3 from $12 to $15 between the start of the month and the purchase on the 5th. Under FIFO, since you use the starting inventory first, the COGS is lower, costing $12 for 60 widgets while the remaining 130 widgets were assigned the $15 acquisition price. Due to the lower cost of goods sold, you recorded a larger gross profit, tax expense and ending inventory.
LIFO Inventory Method
Under the LIFO inventory method, you assign costs of goods sold starting from the most recent purchases to the oldest. Based on our sample case study:
- 1. Using LIFO, Sale X of 190 widgets requires you to apply the most recent costs first. Of the 190 widgets sold, you assign a $15 cost to 140 widgets (from Purchase A) and $12 to the remaining 50 widgets, (from beginning inventory) for a total COGS of $2,700.
- 2. After Sale X, your remaining inventory is 10 widgets accounted for at $12 each, or $120.
In summary, under LIFO:
- COGS = $2,700
- Gross Profits = Sales – COGS = $3,800 – $2,700 = $1,100.
- Ending Inventory = $120.
In our LIFO example, the cost of each widget also increased by $3 from $12 to $15 between the start of the month and the purchase on the 5th. However, because LIFO accounts for latter purchases first, and because more recent prices were higher, LIFO resulted in a higher COGS, lower gross profits, low tax expense and less ending inventory.
Comparing our results and assuming rising prices:
Due to the lower acquisition cost for earlier inventory, FIFO results in a lower cost of goods and larger gross profits than LIFO accounting, resulting in a larger ending inventory value. In contrast, LIFO uses higher recent inventory costs which results in a higher cost of goods sold and lower gross profits. The ending inventory value is also lower due to the oldest acquisition cost being applied to value the remaining inventory.
Advantages and Disadvantages of FIFO vs LIFO
In general, FIFO is preferred by most evaluators. However, LIFO might be a better choice in certain scenarios if you have discretion over which accounting method to apply:
- Companies facing steeply rising costs: If prices are rising rapidly, LIFO helps reduce the tax bite. Supermarkets and pharmacies typically use LIFO because their products are sensitive to inflation. Convenience stores that sell tobacco and liquor are also good LIFO candidates, as these goods also tend get more expensive over time. By increasing your COGS with later more expensive costs, you can reduce your tax liability.
- Companies that use physical LIFO: Certain industries, such as lumber and mining, pile the newest inventory items on top of older ones. By using LIFO accounting, these companies better match their costs and revenues, which is considered a desirable accounting principle.
- Companies that face inventory write-downs during inflation: Inventory is written down when its value falls below its cost. Under LIFO, the remaining balance-sheet value for inventory reflects the oldest, and lowest, prices. Since old inventory is priced more cheaply (in normal inflationary conditions), the company is less likely to write off the inventory. Write-offs are frowned upon because they may indicate issues with profitability. LIFO helps to reduce write-offs, which can be a plus for companies that carry inventory that spoils, is easily damaged, or is vulnerable to obsolescence. Examples include the fashion and agricultural industries.
- Seasonal businesses: It’s important for seasonal businesses to conserve cash during the off season. By using LIFO and assuming generally rising prices, a company can reduce its tax liability, thereby allowing a company to hold on to more of its cash.