What Is the Difference Between FIFO vs. LIFO?
If you're in the retail or manufacturing industry, inventory makes up the most of your assets. Inventory ties up the majority of your business's cash flow, and you can only get your money back (plus profits) after you sell your products. If you want to grow your business, you need strong record-keeping and an effective inventory management strategy.
How well you manage your inventory affects your profits. Inventory is also a critical component of the balance sheet, which impacts your company's overall valuation. Hence, the inventory valuation and accounting methods you use and how well they're carried out are critical parts of your company's foundation.
You're also expected to account for and accurately value your inventory costs at each stage of production and sales to ensure that your company's financial statements are true to International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). Accurate financial statements also provide you with useful insights into the overall performance and growth of your business.
In this article, we'll compare two popular methods of inventory valuation: First In, First Out (FIFO) and Last In, First Out (LIFO).
What Is FIFO?
First In, First Out (FIFO) is an inventory management and valuation method. It assumes that the oldest inventory produced or purchased are sold or used in production first. The FIFO method uses the cost of the oldest stocks to calculate the cost of goods sold (COGS), which is recorded in the income statement. The value of inventory on hand is computed using the price of the most recent inventory purchases.
Since most businesses don't want expired or stale products and strive to use or sell the oldest stocks first, FIFO follows the natural flow of inventory. The simple process prevents mistakes in bookkeeping. This is why the FIFO method is said to be more transparent compared to LIFO.
What Is LIFO?
Last In, First Out (LIFO) is an inventory accounting method that assumes that the newest stocks are sold first. It calculates the COGS with the price of the most recent purchases and uses the cost of the oldest items to value the company's on-hand inventory.
The LIFO method is allowed by GAAP, which is why it's still practiced by businesses in the United States. However, IFRS doesn't allow LIFO as a method for valuing inventory. The IFRS Foundation is an international organization responsible for developing a single set of global accounting standards so financial documents are consistent and comparable worldwide.
What Is the Difference Between FIFO and LIFO?
Here are the main differences between FIFO and LIFO:
- The FIFO method assumes that the oldest stocks are sold or used in production first.
- The LIFO method assumes that the most recent purchases or the newest inventory to arrive is sold or used in production first.
- The FIFO method is an accepted practice around the world, approved by both GAAP and IFRS.
- The LIFO method is allowed by GAAP but prohibited by IFRS.
- The FIFO method follows the natural flow of inventory and a logical approach to avoid inventory losses through obsolescence — expired or stale goods for production or sale.
- The LIFO method can cause inventory losses from obsolete or spoiled goods.
To illustrate the calculation of the COGS and ending inventory balance between the two methods, let's assume the following figures for Wendy's beauty boutique during its first year of operation:
|Cost per Unit
- Total purchases came to $79,750 for the year.
- 10,000 units were sold in total for the year.
Under the FIFO method, the company's cost of sales will amount to:
|3,000 x $5.00
|2,500 x $5.25
|2,000 x $5.75
|1,500 x $5.75
|1,000 x $6.00
With FIFO, Wendy's COGS would be $54,250. The remaining inventory reported on the balance sheet would amount to $25,500.
|Total of All Purchases - COGS
|$79,750 - $54,250
Under the LIFO method, the company's COGS can be calculated as:
|3,000 x $6.50
|2,000 x $6.00
|1,500 x $5.75
|2,000 x $5.75
|1,500 x $5.25
Using the LIFO method, the company would report in its income statement the amount of $59,500 for the COGS. The on-hand inventory would be valued at $20,250.
|Total of All Purchases - COGS
|$79,750 - $59,500
When discussing differences between FIFO and LIFO, a benefit of one can be viewed as a disadvantage of the other. In the next section, we'll explore the advantages of each so you can decide if the FIFO or LIFO method better aligns with your business's goals.
Advantages of FIFO
- Under the FIFO method, the possibility of a higher profit is greater since the COGS is calculated using the price of the oldest inventories (which are generally acquired for lower costs). Businesses that use FIFO report higher net incomes when market prices increase. This is why FIFO is said to give a clearer picture of a business's profitability and growth.
- Proponents of FIFO also claim that it's a better measure for valuing inventory on hand. It uses the per-unit cost of the most recent purchases, which ties to the current market value of the products.
Advantages of LIFO
- LIFO accounting assigns the cost of the most recent purchases to calculate the accounting period's COGS. In a market where per-unit costs of stocks increase, this results in a lower taxable income for a company. Lower profit means lower tax liability, which is the greatest advantage of using the LIFO method.
- Since the LIFO method allows a business to lower its income tax, this also means less cash outlay and a higher cash flow for the company.
What Types of Businesses Use the FIFO and LIFO Methods?
If the market prices of raw materials and products didn't fluctuate, it would make no difference if businesses used the FIFO or LIFO method. But prices change, and they mostly increase.
In a market of rising prices, companies that use the LIFO valuation are those with relatively large inventories that can take advantage of lower taxes and higher cash flows. On the other hand, the FIFO method is preferred by businesses that want to attract investors or lenders with higher profits and net worth during periods of inflation — increasing market prices.
Dell Computer (page 100), uses the FIFO method to account for inventories in its financial statement. In contrast, Walmart (page 56) and Target (page 43) use LIFO as their inventory valuation method. However, since LIFO is not recognized outside of the U.S., Walmart uses FIFO for its international segment.
For comparability with other companies, U.S. public companies must publish what's known as LIFO reserves in the footnotes of their financial statements. LIFO reserves represent the difference between ending inventory under LIFO and under another system, which is usually FIFO.
The Internal Revenue Service (IRS) also states that companies need to be consistent in reporting values of inventory items, which means you're not allowed to use LIFO for tax purposes and FIFO for accounting purposes.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're using the inventory valuation method best suited for your business needs.