FIFO vs LIFO: Choose a Right Inventory Method for Inventory Valuation
There are multiple ways to manage the Inventory in Business. We frequently use an approach of FIFO vs LIFO vs Average Costing etc. Each business has a way to decide what Inventory Method to use as it has an impact on the inventory Costing. Each has different reasons for using and valuing Inventory.
What is FIFO and LIFO?
Key differences are as below. These practices decides how the inventory costs to be treated, how the flow of inventoryand consumption happens, the method of inventory valuation to be taken into financial statements.
FIFO (First-In-First-Out) and LIFO (Last-In-First-Out) are two popular inventory valuation methods used by businesses to track and manage their inventory. Both methods have distinct approaches to valuing inventory, and the choice between FIFO and LIFO can significantly impact a company’s financial statements and tax liabilities.
FIFO Method: In the FIFO method, the first items added to inventory are assumed to be the first ones sold. In other words, the oldest inventory is sold first, and the cost of goods sold (COGS) is based on the most recent inventory purchases.
LIFO Method: In contrast, the LIFO method assumes that the last items added to inventory are the first ones sold. This means that the most recent inventory purchases are considered to be sold first, and the COGS is based on the oldest inventory.
Method of inventory valuation helps to decide product costing and what to show as consumption and at what costs. Most of the perishable products are treated under FIFO approach, while few items follow LIFO accounting model. It all depends on business practices and how they want to manage their product costing in Balance sheet or Income statements. These are all within international accounting principles.
inventory management software can help to manage these LIFO or FIFO or Average costing models with manage Inventory balance with right unit cost, match physical inventory with stock in the software etc.
In LIFO and FIFO model the purchase price is taken as product unit cost, while in average costing model, there may be difference in Unit cost of product and what price the item is purchased.
When to use FIFO vs LIFO or LIFO vs FIFO?
The choice between FIFO and LIFO depends on various factors, including the company’s inventory management goals, cost trends, tax implications, and industry standards.
Use FIFO When:
- Prices are rising: FIFO tends to result in a higher ending inventory value during inflationary periods, as the older, lower-cost inventory is left in stock, while the higher-cost inventory is assumed to be sold first. This can lead to lower COGS and higher profits on the income statement.
- Matching principle is essential: FIFO aligns with the matching principle, which states that expenses should be matched with revenues in the same accounting period. As FIFO assumes that older inventory is sold first, the cost of goods sold closely corresponds to the revenue generated from those sales.
- Perishable goods: For businesses dealing with perishable goods or products with expiration dates, FIFO ensures that older inventory is sold first, reducing the risk of obsolescence.
Use LIFO When:
- Prices are falling: LIFO is advantageous during deflationary periods since the most recent, lower-cost inventory is assumed to be sold first. This results in higher COGS and potentially lower taxable income, which may reduce tax liabilities.
- Inventory turnover is high: LIFO can be beneficial for businesses with rapid inventory turnover, as it reflects the current market costs in COGS, providing a more accurate representation of the company’s current financial position.
- Tax benefits are a priority: LIFO’s higher COGS can lead to reduced taxable income and, consequently, lower tax liabilities, which may be advantageous for businesses seeking to manage their tax burden.
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What are the advantages of FIFO vs LIFO?
Advantages of FIFO:
- Better matching of costs and revenues: FIFO ensures that the cost of goods sold is based on older inventory, which more accurately reflects the costs associated with the corresponding revenue.
- Higher ending inventory value in inflationary environments: During periods of rising prices, FIFO results in a higher ending inventory value on the balance sheet, which can boost a company’s perceived financial health.
- Reduced risk of obsolescence: In industries where products become obsolete quickly, FIFO helps in selling older inventory first, reducing the risk of holding obsolete stock.
Example: A smartphone retailer using FIFO sells the older models first, ensuring that newer models with enhanced features are not left unsold as technology advances
Advantages of LIFO:
- Tax benefits in inflationary environments: LIFO’s higher COGS in times of inflation can lead to lower taxable income and, consequently, reduced tax liabilities.
Example: A toy manufacturer using LIFO during an inflationary period can offset the impact of rising material and production costs, resulting in lower taxable income.
- Reflects current market costs: LIFO reflects the most recent inventory purchases in COGS, providing a more accurate representation of current market costs.
Example: An electronics retailer using LIFO can pass on recent price reductions to customers, reflecting current market prices in their pricing strategy.
Explain with Examples for FIFO Inventory method
Example: XYZ Electronics, a consumer electronics retailer, adopts the FIFO inventory method. In the first quarter, they purchased 50 units of a popular smartphone model at $300 each. Later, in the second quarter, they acquired an additional 70 units of the same model at $350 each.
During the first half of the year, XYZ Electronics sold a total of 90 smartphones. According to FIFO, the COGS for these sales would be calculated based on the cost of the oldest inventory (first quarter purchases).
COGS calculation: First 50 units sold at $300 each: 50 units * $300 = $15,000 Next 40 units sold at $350 each (remaining from second quarter purchases): 40 units * $350 = $14,000
Total COGS = $15,000 + $14,000 = $29,000
As per FIFO, the ending inventory value at the end of the second quarter would be based on the cost of the remaining 30 units from the second quarter purchases, i.e., 30 units * $350 = $10,500.
Explain LIFO Examples
LIFO Examples
ABC Hardware, a building materials supplier, follows the LIFO inventory method. In the first quarter, they purchased 100 bags of cement at $10 per bag. In the second quarter, they acquired an additional 80 bags at $12 per bag.
During the first half of the year, ABC Hardware sold a total of 120 bags of cement. According to LIFO, the COGS for these sales would be calculated based on the cost of the most recent inventory (second quarter purchases).
COGS calculation: First 80 units sold at $12 each (second quarter purchases): 80 units * $12 = $960 Next 40 units sold at $10 each (remaining from first quarter purchases): 40 units * $10 = $400
Total COGS = $960 + $400 = $1,360
As per LIFO, the ending inventory value at the end of the second quarter would be based on the cost of the remaining 60 units from the first quarter purchases, i.e., 60 units * $10 = $600.
Differences between FIFO vs LIFO vs Average Costing.
FIFO, LIFO, and Average Costing are three different methods used to value inventory, each with its distinct advantages and applications.
FIFO:
- Assumes that the oldest inventory is sold first.
- Leads to higher ending inventory value during inflationary periods.
- Better matches costs with revenues.
- Suited for industries with perishable goods.
- Recommended for companies following the matching principle.
LIFO:
- Assumes that the most recent inventory is sold first.
- Provides tax benefits during inflationary periods.
- Reflects current market costs in COGS.
- Suitable for businesses with rapid inventory turnover.
- May lead to lower ending inventory value during inflationary periods.
Average Costing:
- Calculates the average cost of all units in inventory.
- Provides a middle-ground approach between FIFO and LIFO.
- Can be used when FIFO and LIFO are not practical or allowed for tax purposes.
- Smoothes out the impact of cost fluctuations.
- Useful for businesses with stable and consistent pricing.
FAQ on LIFO vs PIFO
Which inventory method is better for tax purposes?
LIFO is advantageous for tax purposes during inflationary periods due to its ability to reduce taxable income and tax liabilities.
Does the choice between FIFO and LIFO impact financial ratios?
Yes, the choice of inventory method can impact financial ratios such as gross profit margin and inventory turnover.
Can a company switch between LIFO and FIFO?
Yes, a company can change its inventory valuation method, but the change must be disclosed in the financial statements.
Does LIFO or FIFO affect cash flow?
The choice between FIFO and LIFO can affect cash flow, as it impacts the timing of tax payments and the company’s reported financial results.
Which inventory method is more commonly used in practice?
FIFO is more commonly used in practice, especially for industries with perishable goods or those following the matching principle.
In conclusion, choosing between FIFO and LIFO can significantly impact a company’s financial reporting, tax liabilities, and overall business performance. Each method has its advantages and applications, and businesses must carefully consider their unique circumstances and objectives before selecting the most suitable inventory valuation method. Properly managing Work-in-Process Inventory alongside the chosen inventory method ensures accurate product costing and efficient inventory control, contributing to the success of the business in the competitive market.