Inventory is a crucial part of a business’s assets. For most companies, it not only represents the largest portion of overall assets, but inventory can also potentially impact investor support and their taxes, making it important for organizations to understand how best to account for it. FIFO & LIFO have long been considered the best accounting methods to account for inventory and the total cost of goods sold (COGS).
In this blog, we will learn everything there is to know about FIFO vs LIFO to help you better understand which of these is best for your business accounting.
Please note that moving forward, we will define inventory as the stock of produced or purchased goods intended to be sold by a business.
FIFO vs LIFO: What Are The Differences?
FIFO and LIFO accounting methods are easy to understand in principle, but get more complicated in practice.
Let’s start with some quick definitions: FIFO, which stands for “First In, First Out” operates under the assumption that a company’s oldest products have been sold first. LIFO, which stands for “Last In, First Out” operates under the assumption that a company’s newest products have been sold first.
FIFO and LIFO are just assumptions — each method doesn’t have to reflect the inventory being sold, just the inventory totals. So, a company using the FIFO method could actually sell the more recent stock first, and a company using the LIFO method could sell the older stock first, but for the COGS calculation, we need to assume that the inventory is being sold in the respective order.
Pretty simple so far! But the method that a company chooses to use will make a big impact on their profits, which in turn impacts their total taxes, so there are a few things to consider first:
FIFO vs LIFO Taxes & Accounting: Which Method Is Better?
In most cases, FIFO is the more realistic method of the two. The basic principles of production would assume that older stock is being used up before newer stock. Most companies will try to offload older stock first to avoid it sitting unused in inventory.
However, in times of rising costs and inflation, LIFO accounting could be more beneficial for companies than FIFO accounting. When using LIFO during a period of inflation, companies would report a lower profit based on the cost of goods sold, which could save them money on taxes, while also being able to better align their revenue numbers with the most recent product costs.
How to Calculate COGS using FIFO and LIFO
No matter which method you use, your calculations must take into account any fluctuations in the prices paid for the inventory. This calculation must also only account for a sold product – any unsold inventory cannot be applied to the cost of goods calculation.
To calculate the COGS using the FIFO method, multiply the cost of your oldest inventory by the amount of inventory sold.
To calculate the COGS using the LIFO method, multiply the cost of your most recent inventory by the amount of inventory sold.
Understanding FIFO and LIFO With Examples
Imagine that you own a paper products company. On Monday, you receive a shipment of 200 notebooks, all priced at 1 dollar each. On Tuesday, you receive a shipment of 200 notebooks priced at 2 dollars each. If you sold 200 notebooks on Wednesday and used FIFO to calculate, the cost of goods sold would be 200 dollars (1 dollar x 200). The 2 dollar notebooks left in stock would be used to calculate the total value of inventory at the end of the accounting period.
However, if you used LIFO to calculate your cost of goods sold, the total would be 400 dollars (2 dollars x 200). The remaining 1 dollar notebooks would be used to calculate the value of the inventory at the end of the period.
In many cases, LIFO doesn’t necessarily provide a realistic assessment of the valuation of inventory, because the older stock is often considered obsolete or less valuable. It is also not realistic for most companies, as those selling perishable goods would not leave their oldest inventory sitting in stock – that inventory would ideally be sold first.
FIFO and LIFO both are necessary to evaluate inventory costs because of inflation. If not for inflation, all inventory production costs would remain stable, so each method of valuation would produce the same results. Because prices rise over time, the choice of which accounting method to use can affect the inventory valuation and profitability over the period. Choosing either FIFO or LIFO can have tax implications, depending on the current state of inflation.
The Global Perspective: FIFO vs LIFO
It’s important to note that LIFO and LIFO accounting are not treated equally outside of the United States. LIFO is only permitted within the United States, so most companies using LIFO in their American operations will switch to FIFO when accounting for their international operations.
Pros and Cons; FIFO vs LIFO
FIFO is more likely to get accurate results. This is because calculating stock profit is straightforward, making it simple to update your financial records and save time and money.
Moreover, it avoids out-of-date goods from being re-counted or from remaining idle for too long. resulting in lost income and resource waste.
Inflation is taken into account while employing the FIFO approach. The reason for this is that you are purchasing goods as the economy evolves.
The FIFO approach has several drawbacks as well. One of these is that employing this strategy to increase profit also necessitates paying more tax.
Moreover, clerical mistakes might happen since a large quantity of data is needed to derive the cost of items. FIFIO can miscalculate profit outcomes when balancing your beginning and ending inventories because of changes in economic cycles.
LIFO is advantageous for individuals who seek to minimize their tax obligations. Retail businesses who seek to follow trends and fast-move in-vogue products may find it effective. Or for establishments like supermarkets that wish to manage the varying costs of food.
This approach also has drawbacks. One of them is the fact that even if you could pay less tax, you’ll still need to report a reduced profit. Keeping track of the worth of your merchandise and all the layers might be challenging due to price fluctuations. making it difficult to stay on top of paying taxes and earnings.