What inventory management method should you use for your business? Learn about FIFO and LIFO to help you decide.
- FIFO (first in, first out) inventory management seeks to sell older products first so that the business is less likely to lose money when the products expire or become obsolete.
- LIFO (last in, first out) inventory management applies to nonperishable goods and uses current prices to calculate the cost of goods sold.
- Both U.S. and international standards are moving away from LIFO. Many U.S.-based companies have switched to FIFO
- This article is for small business owners who want to learn about inventory management methods.
Inventory management is a crucial function for any product-oriented business. First in, first out (FIFO) and last in, first out (LIFO) are two common methods of inventory valuation for businesses. The system you choose can have profound effects on your taxes, income, logistics and profitability. Learn how both methods work and the major differences between them; then consult your CPA or tax attorney to determine the best method for your business.
What is FIFO, and how does it work?
Companies operating on the principle of first in, first out value inventory on the assumption that the first goods purchased for resale become the first goods sold. In some cases, this may not be true, as some companies stock both new and old items.
Due to the fluctuations of the economy and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered more profitable – at least on paper. For example, a grocery store purchases milk at regular intervals to stock its shelves. As customers purchase milk, the stockers push the oldest product to the front of the fridge and replace newer milk behind those cartons. The cartons of milk with the nearest expiration dates are thus the ones first sold, whereas the cartons with the later expiration dates are sold after the older ones. This process ensures that older products are sold before they perish or become obsolete, thereby avoiding lost profit.
Companies that sell perishable products or units subject to obsolescence, such as food products or designer fashions, commonly follow the FIFO method of inventory valuation.
Anil Melwani, CPA and president of New York accounting firm 212 Tax & Accounting Services, said that because prices rise in the long term, the choice of accounting method can significantly affect valuations.
"FIFO gives us a better indication of the value of ending inventory on the balance sheet, but it also increases net income, because inventory that might be several years old is used to value the cost of goods sold," Melwani said. "Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay."
For businesses that need to impress investors, this becomes an ideal method of valuation, until the higher tax liability is considered. Because FIFO results in a lower recorded cost per unit, it also records a higher level of pretax earnings. And with higher profits, companies will likewise face higher taxes.
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How to calculate FIFO
To calculate the cost of goods under FIFO, begin by determining the cost of your oldest inventory, said Stephanie Ng, a CPA and founder of the CPA exam preparation website I Pass the CPA Exam. "Then, multiply this cost by the number of inventory items sold to determine the costs associated with the sale of inventory using FIFO," Ng said.
For the purposes of this calculation and the ones that follow, we will focus on periodic FIFO. Here is Ng's sample formula:
Beginning inventory ($X,XXX) + Purchases ($X,XXX) = Goods available for sale - Ending Inventory (from physical count) ($X,XXX) = Cost of goods sold ($X,XXX)
"You can change the order of this equation to solve for the ending inventory," Ng said. "So, ending inventory using the FIFO method is the goods available for sale less the costs of goods sold. When a physical inventory count hasn't occurred, this can be used to back the ending inventory amount."
Example of FIFO
Once you understand what FIFO is and what it means for your business, it's important to learn how it works. Ng offered an example of FIFO using real numbers to show the formula in action.
"Suppose Candle Corporation is in its first year of operations, and they purchased two batches of inventory throughout the year," she said. "Batch 1 was for 3,000 units at $1.25 per unit. Batch 2 was for 6,000 units at $1.75 per unit. Seven thousand units were sold in total. Two thousand units were sold after the first purchase, 5,000 units were sold after the second purchase. To calculate ending inventory and costs of goods sold using FIFO in a periodic inventory system, start by calculating goods available for sale."
Using this example and the above formula, this is how Candle Corporation would calculate its goods available for sale:
Beginning inventory ($0) + Batch 1 purchases (3,000 units @ $1.25 each: $3,750) + Batch 2 purchases (6,000 units @ $1.75 each: $10,500) = Goods available for sale ($14,250)
"Ending inventory isn't given in this scenario, so you can use the cost of goods sold to 'squeeze' out this value," Ng explained. "You know under FIFO, you need to first account for selling your oldest inventory first. In this case, Batch 1 is the oldest, so we want to first use up all that inventory. Then, the remainder will come from Batch 2. Keep in mind that 7,000 units in total were sold." Here's how Ng calculated the total cost of goods sold (COGS) using periodic FIFO:
COGS from Batch 1 (3,000 units @ $1.25 each: $3,750) + COGS from Batch 2 (4,000 units @ $1.75 each: $7,000) = Total COGS ($10,750)
Now, you can calculate the ending inventory:
Goods available for sale ($14,250) - COGS ($10,750) = Ending inventory ($3,500)
"When determining the cost of goods sold or ending inventory using periodic FIFO, it doesn't matter when the inventory was sold," Ng said. "It's just important to use up the oldest inventory first."
Key takeaway: The goal of FIFO inventory management is to reduce inventory waste by selling older products first.
What is LIFO, and how does it work?
The last in, first out method of inventory entails using current prices to calculate the cost of goods sold, as opposed to using what was paid for the inventory already in stock. If the price of such goods has increased since the initial purchase, the cost of goods sold will be higher and thereby reduce profits and tax burdens. Nonperishable commodities – like petroleum, metals and chemicals – are frequently subject to LIFO accounting.
"LIFO isn't a good indicator of ending inventory value, because the leftover inventory might be extremely old and, perhaps, obsolete," Melwani said. "This results in a valuation much lower than today's prices. LIFO results in lower net income because the cost of goods sold is higher, so there is a lower taxable income.
"By using more recent inventory in valuation," Melwani continued, "your cost basis is higher on current income statements. This reduces gross profit and, ultimately, net income. This is the implication of LIFO, and many companies prefer LIFO because lower profit reporting means a reduced tax burden."
How to calculate LIFO
Ng offered a formula for calculating LIFO as well. For the purposes of this and the following formulas, we will again focus on periodic LIFO. Much of the process is the same as it is for FIFO, including this basic formula, according to Ng. She noted that the differences come when determining which goods you're going to say you sold.
Beginning inventory ($X,XXX) + Purchases ($X,XXX) = Goods available for sale - Ending inventory (from physical count) ($X,XXX) = Cost of goods sold ($X,XXX)
Example of LIFO
As an example of how LIFO works, suppose a website development company purchases a plugin for $30 and then sells the finished product for $50. However, several months later, that asset has increased in price to $35. When the company calculates its profits, it would use the most recent price of $35. In tax statements, it would then appear as if the company made a profit of only $15. By using LIFO, a company would appear to be making less money than it actually did and, therefore, have to report less in taxes.
Let's look at another example from Ng. For LIFO, she revisited the Candle Corporation example, using the same batch-purchase numbers and prices as the FIFO example, for the sake of simplicity. First, let's calculate the total cost of goods sold, again abbreviated as COGS.
"Under LIFO, you need to account for selling your newest inventory first. Because Batch 2 was purchased more recently, you want to use up that inventory first," Ng explained. "Only 6,000 units were purchased in Batch 2, but 7,000 units were sold. That means you should use up the 6,000 first, and then use the remaining 1,000 units sold from Batch 1."
For the sake of simplicity once again, Ng kept the purchase prices the same and did not determine if the current price was higher or lower. Let's look at the numbers:
COGS from Batch 2 (6,000 units @ $1.75 each: $10,500) + COGS from Batch 1 (1,000 units @ $1.25 each: $1,250) = Total COGS ($11,750)
Now, we'll need to calculate the ending inventory:
Goods available for sale ($14,250) - COGS (11,750) = Ending inventory ($2,500)
The principle of LIFO is highly dependent on how the price of goods fluctuates based on the economy. If a company holds inventory for a long time, holding on to products may prove quite advantageous in hedging profits for taxes. LIFO allows for higher after-tax earnings due to the higher cost of goods. At the same time, these companies risk that the cost of goods will go down in the event of an economic downturn and cause the opposite effect for all previously purchased inventory.
Key takeaway: LIFO inventory management allows businesses with nonperishable inventory to take advantage of price increases on newer stock to calculate a higher cost of goods sold, allowing these businesses to report less profit on their taxes.
FIFO and LIFO similarities and differences
FIFO and LIFO are quite different inventory management techniques. However, they are similar in one regard: Both depend on the product remaining the same, with price being the only fluctuating element.
FIFO and LIFO influence a company's earnings on paper. FIFO is most successful when used in an industry in which the price of a product remains steady and the company sells its oldest products first. That's because FIFO is based on the cost of the first goods purchased, ignoring any increases or reductions in price for newer units. LIFO, in comparison, works well in an industry in which prices fluctuate and the newest units are sold first.
"Because FIFO results in a higher net income during periods of rising prices, it also results in higher income tax expenses," Ng said. "Conversely, if the LIFO method is used during a period of rising prices, it will result in lower net income. So, this method would result in a lower income tax expense."
Another main difference is that FIFO can be utilized for both U.S.- and internationally based financial statements, whereas LIFO cannot.
Key takeaway: FIFO and LIFO allow businesses to calculate COGS differently. From a tax perspective, FIFO is more advantageous for businesses with steady product prices, while LIFO is better for businesses with rising product prices.
Restrictions on the use of LIFO
LIFO is banned by International Financial Reporting Standards (IFRS), a set of common rules for accountants who work across international borders. While many nations have adopted IFRS, the United States still operates under the guidelines of generally accepted accounting principles (GAAP). If the United States were to ban LIFO, the country would clear an obstacle to adopting IFRS, thus streamlining accounting for global corporations.
Because of the current discrepancy, however, U.S.-based companies that use LIFO must convert their statements to FIFO in the footnotes of their financial statements. This difference is known as the LIFO reserve and is calculated between the cost of goods sold under LIFO and FIFO, Melwani said. This increases the comparability of LIFO and FIFO firms.
In general, both U.S. and international standards are moving away from LIFO. Many U.S.-based companies have switched to FIFO, and some companies still use LIFO within the United States as a form of inventory management but translate it to FIFO for tax reporting. Only a few large companies within the United States can still use LIFO for the purpose of tax reporting.
Many companies believe the repeal of LIFO would result in a tax increase for both large and small businesses, though many other companies use FIFO with little financial repercussion.
"While it's up to management to choose the most appropriate cost flow assumption, FIFO best reflects the physical flow of inventory," Ng said. "Management should consider the business's model, tax implications and international financial requirements (if any) before choosing LIFO or FIFO."
Key takeaway: Although LIFO is a GAAP-accepted practice, it's banned under international accounting standards. U.S. businesses are moving away from it as well, and those that use it for inventory management may still use FIFO for tax reporting.
Additional reporting by Jennifer Post and Ryan Goodrich. Some source interviews were conducted for a previous version of this article.