Inventory management is a crucial function for any product-oriented business. First in, first out (FIFO) and last in, first out (LIFO) are two standard methods of valuing a business’s inventory. Your chosen system can profoundly affect your taxes, income, logistics and profitability.
We’ll explore how both methods work and how they differ to help you determine the best inventory valuation method for your business.
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Companies that operate on the principle of first in, first out value inventory on the assumption that the first goods the business manufactures or purchases should become the first goods sold. (This may not be true in some instances, as some companies stock both new and old items.)
Due to economic fluctuations and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered more profitable – at least on paper. Companies that sell perishable products or units subject to obsolescence, such as food products or designer fashions, commonly follow the FIFO inventory valuation method.
For example, a grocery store purchases milk regularly to stock its shelves. As customers purchase milk, stockers push the oldest product to the front and add newer milk behind those cartons. Milk cartons with the soonest expiration dates are the first ones sold; cartons with 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.
Anil Melwani, CPA and partner at New York accounting firm Tanton Grubman CPAs LLP, said that because prices rise in the long term, a business’s accounting method choice 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.”
FIFO is an ideal valuation method for businesses that must impress investors – 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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To calculate the cost of goods sold (COGS) 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.”
For the purposes of this calculation and the ones that follow, we’ll focus on periodic FIFO. Here is Ng’s sample formula:
Beginning inventory + Purchases = Goods available for sale – Ending inventory = 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.”
Once you understand what FIFO is and what it means for your business, it’s crucial 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, [and] 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. “Under FIFO, you need to first account for selling your oldest inventory. 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 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.”
The last in, first out inventory method uses current prices to calculate the cost of goods sold instead of what you paid for the inventory already in stock. If the price of goods has increased since the initial purchase, the cost of goods sold will be higher, thus reducing profits and tax liability. Nonperishable commodities (like petroleum, metals and chemicals) are frequently subject to LIFO accounting when allowed.
“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.”
Reduced tax liability is a key reason some companies prefer LIFO. “By using more recent inventory in valuation, your cost basis is higher on current income statements,” Melwani said. “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.”
Ng offered a formula for calculating LIFO. We will again focus on periodic LIFO for this and the following formulas. According to Ng, much of the process is the same as it is for FIFO, including this basic formula. She noted that the differences come when you’re determining which goods you’re going to say you sold.
Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold
Suppose a website development company purchases a plugin for $30 and then sells the finished product for $50. Then, several months later, the plugin price increases to $35. When the company calculates its profits, it would use the most recent price of $35. In tax statements, it would appear that 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.
Ng offered another example, revisiting the Candle Corporation and its batch-purchase numbers and prices. First, we’ll calculate the total cost of goods sold.
“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, Ng kept the purchase prices the same and didn’t determine if the current price was higher or lower. Here are the numbers in action:
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, it 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.
LIFO inventory management allows businesses with nonperishable inventory to take advantage of price increases on newer stock. On their accounting reports, they can calculate a higher cost of goods sold and then report less profit on their taxes.
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 their financial statement footnotes. This difference is known as the “LIFO reserve.” It’s calculated between the cost of goods sold under LIFO and FIFO. 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. Some companies still use LIFO within the United States for inventory management but translate it to FIFO for tax reporting. Only a few large companies within the United States can still use LIFO for tax reporting.
Some companies believe repealing LIFO would result in a tax increase for both large and small businesses, though many other companies use FIFO with few financial repercussions.
“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.”
Although LIFO falls under GAAP, it’s banned under international accounting standards. U.S. businesses are moving away from LIFO; those that use it for inventory management may still use FIFO for tax reporting.
FIFO and LIFO are very different inventory management techniques. However, they are similar in one regard: Both depend on the product remaining the same, with the company’s cost basis (its manufacturing cost or acquisition price) being the only fluctuating element.
FIFO and LIFO influence a company’s earnings on paper. Here are the key differences:
Another difference is that FIFO can be utilized for both U.S.- and internationally based financial statements, whereas LIFO cannot.
Whether you use FIFO or LIFO, you’ll need accounting software to track your finances and make accurate calculations. Check out our reviews of the best accounting software to record and report your business’s financial transactions.
While FIFO and LIFO sound complicated, they’re very straightforward to implement. The best POS systems will include inventory tracking and inventory valuation features, making it easy for business owners and managers to choose between LIFO and FIFO and use their chosen method.
If you’re unclear on whether FIFO or LIFO is better for your business (though LIFO is increasingly rare, as it’s prohibited by some accounting standards), an inventory management tool can help you compare the impacts of FIFO and LIFO on your bottom line.
Of course, choosing between LIFO and FIFO isn’t a lifetime commitment. Even if you’ve been using one or the other for years, you can always change methods, though you should seek the guidance of a CPA during this somewhat complicated process.
In addition to FIFO and LIFO, which are historically the two most standard inventory valuation methods because of their relative simplicity, there are other methods. The most common alternative to LIFO and FIFO is dollar-cost averaging.
Dollar-cost averaging involves averaging the amount a company spent to manufacture or acquire each existing item in the firm’s inventory. As inventory is sold, the basis for those items is assumed to be the average inventory cost at the time of their sale. Then, as new items are added to the company’s inventory, the average value of items in the firm’s updated inventory is adjusted based on the prices paid for newly acquired or manufactured items.
Inventory valuation can be tedious if done by hand, though it’s essentially automated with the right POS system. Although picking which method to use may seem trivial, the subtle differences between FIFO and LIFO inventory management can add up to thousands of dollars (or even more for large companies) of tax savings each year.
That’s why it’s essential to track your business’s inventory carefully while identifying and implementing the best inventory valuation method to maximize your net profit each year and minimize your tax burden from sales.
Dock Treece, Jennifer Post and Ryan Goodrich contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.