When your SKUs arrive at the storage location, it is essential to plan out the removal strategy of your stocks. Based on the time of releasing the stock, it is categorized into three different strategies- LIFO, WAC, and FIFO.
A removal strategy is vital to plan out as it ensures quality control, removal of first products, and moving out the products with the closest expiration date. A correct and practical approach increases customer satisfaction and expands your business. Let’s now look at one of the removal strategies- LIFO.
What Is Last In, First Out (LIFO)?
LIFO stands for last in, first out. It is an inventory valuation method that suggests selling the stocks that arrived late at the storage location. In simpler words, the latest commodities received at the location are sold first. This causes the old inventory costs to remain on the balance sheet, and the newest inventory costs are expensed instead.
More removal strategies or inventory valuation methods exist to calculate your unsold inventory stocks. These methods differ from each other to a great extent and also exert different impacts on your inventory stocks. Let’s look at the different inventory valuation methods and the steps to calculate them.
Inventory Valuation Methods
Inventory valuation is the calculation of accounting price by the company to determine the value of unsold inventory. These methods are used to calculate the total value of the stock at a particular time. This helps you further define the turnover ratio of your inventory.
The four widely used inventory valuation methods are- FIFO, LIFO, FEFO, and WAC. Let’s take a look at these methods with the help of an example.
- First in, First out (FIFO):
In FIFO, assets are produced and acquired first and sold, used, or removed first. For example, if three items, A, B, and C, arrived on 1/01/22, 2/01/22, and 3/01/22, respectively, then item A, received on 1/01/22, will be sold out first, followed by B and C. Therefore, the sellers show the oldest items sold in their balance sheet.
- Last in, First out (LIFO):
In this strategy, the stocks which arrive last at the location are sold or removed first. If products A, B, and C are delivered in this order, item C will be removed or sold first in the market. Therefore, the sellers show the newest items sold in their balance sheet.
- First expired, First out (FEFO):
This strategy is different from the previous two. It does not depend on the time of arrival of the stock. Instead, it deals with the expiration dates of inventory stocks. For example, if item B expires sooner than items A and C, the seller would sell out item B first, then the other two. It works best for industries that contain perishable goods.
- Weighted Average Cost (WAC):
This valuation method includes inventory and costs of goods sold (COGS). It calculates the average price of all purchased items in a specific period.
The formula to calculate Weighted Average Cost (WAC) is
WAC per unit = Cost of goods available for sale/Units available for sale
Cost of goods = Starting inventory value + purchases, and
Units available for sale (Total number of inventory in units) = Beginning of inventory in units + purchases of units
Calculating the cost of goods sold
Cost of goods sold (COGS) is the total cost of goods produced by the company, which is then prepared to be sold. The price includes the value of existing goods, the materials used in the making, labor costs, packing, and transportation costs. COGS is only valid for the producing firm, i.e., the company that makes the goods.
The formula to calculate your cost of goods sold (COGS) is as follows-
COGS = Starting Inventory + Purchases- Ending Inventory
The starting inventory value depends on the period of your business. If you have started your business recently, the starting inventory would be zero. If your firm has been established for a while, your starting inventory value would be the same as the ending inventory in the previous year. The calculation of inventory valuation methods is based on the total cost of purchasing the inventory and getting it ready for sale in the market.
What is LIFO, and How Does It Work?
One of the inventory valuation methods is LIFO which stands for Last in, First out. In this method of removing strategy, the stock purchased last is sold out first in the market. This means that the customers get the newest item first. The results obtained in LIFO are that the oldest inventory stock remains on the balance sheet, while the latest store keeps changing.
Oil companies, automotive, and pharmaceutical industries are more prone to use the LIFO method because of the frequency increase in the cost and shipping of products. The LIFO method is beneficial in the case of inflation as the cheap commodities, or products whose prices are rising, are sold out first. The increase in price increases the COGS, in which the net profit earned by the company becomes less. Henceforth, the tax liability also decreases (or sometimes a tax holiday occurs), and the company has to pay low taxes.
How to calculate LIFO
Suppose you bought stocks of tablets (or tabs) at different prices at different times. You received the first stock of 10 tablets for $1000 each. Then you received the second stock after the first one with five tablets for $1100 each. You received an order for four tablets. Now look at the calculation part-
Going by the LIFO method, the second stock, the newest one, will be taken out first. Therefore-
4 tablets of $1100 each= 4*1100= $4400.
This is the total cost of total items sold, which is four.
There are still ten tablets in the first stock and one in the second available. Calculating the accounting balance of the inventory account, you’ll get-
1100+ 10000= $11000 of the accounting balance of the inventory account.
If you deeply scrutinize the calculations, you’ll notice that the retailers will earn the least profit by selling the newest commodities (which were at higher prices) as the COGS have also increased. In this example, they sold the items worth $4400, which would’ve been $4000 otherwise if they’d gone by the FIFO method.
Restrictions on the use of LIFO
Although it sounds beneficial to retailers because of the price change, some restrictions have been imposed on using the LIFO method. Sellers can use the method in the United States under General Acceptance Accounting Principles (GAAP). In countries such as Canada, India, and Russia, LIFO is required to go by the rules of the International Financial Reporting Standard (IFRS).
One of the reasons for restrictions is concerned with the profitability and financial statement of the company. For instance, LIFO can understate or overstate the company’s statement depending on the inflation rate. It can also affect outdated inventory valuations.
Some firms use LIFO to escape the tax liability on the inventory sold. As discussed, a higher amount results in a higher COGS value, leaving you with little profit. With that profit, the company is not obliged to pay higher taxes. Instead, the company pays a lower tax, which can benefit some firms.
However, in their defense, the firms have proclaimed that the tax saved is invested back into the business, which causes no consequences to the country’s economy. Whatever the case, sellers can use the LIFO inventory method to manipulate or alter the financial statement or save themselves from paying taxes.
Another factor that causes a restriction on the LIFO is old inventory stock remains unattended on the balance sheet. Since the LIFO method places the newest items before the oldest ones, the inventory of the first arrived items remains as it is on the balance sheet creating an imbalance. Hence, it would lead to complexity in calculation and accounting.
When is the LIFO Method Used?
The oil, petroleum, pharmaceutical, and automotive industries use the LIFO method. These industries take years to establish their names in the market. Moreover, they know how to calculate and predict LIFO liquidation during deflation or inflation.
One reason to use the LIFO method would be the frequent shipping of goods. Like the industries mentioned above, the shipment is frequent; therefore, the LIFO method suits their business.
Another reason to use the LIFO method might be a lower tax liability. Companies use the LIFO inventory method to prepare and show the financial statement to the government. This is the reason why many firms oppose businesses with the LIFO method because of the chances of statement manipulation. At the time of inflation, many companies switch from their previous method to LIFO. This saves their tax money and earns a maximum profit.
Example of LIFO
Two scenarios can affect the profit and financial statement generated from the LIFO method. We’ll understand both cases with the help of an example of a stationary retailer. The transaction happened between 2019-2021. In the first scenario, the prices increase, and in the latter, the prices go down.
Scenario 1: Purchase cost increases with time.
From 2019-2021, the number of items (pens) in each stock is 100 units.
|Number of pens present
|Cost per pen
|Stock 1 (Oldest)
|Stock 3 (Latest)
If you receive the order of 250 pens, then it will cost you $400 of COGS (cost of goods sold). Going by the LIFO method, you’ll roll out the newest stock first, which is more expensive. This will make you less profit.
Scenario 2: Purchase cost decreases with time.
This time, the purchase cost has reduced with time, therefore-
|Number of pens present
|Cost per pen
|Stock 1 (Oldest)
|Stock 3 (Latest)
If you receive the order of 250 pens, it will cost you $235 of COGS. Again, going by the LIFO method, you’ll roll out the newest stock first, which is cheaper in this case. This will make you more profit.
Comparison of LIFO and FIFO
Let’s understand this concept with the help of comparison. This comparison would be based on some measures on which both methods depend.
- Meaning: LIFO stands for Last in first out, whereas FIFO stands for first in first out
- Stock: LIFO represents the newest stock, whereas FIFO represents the oldest stock
- Current market price: LIFO shows the current market price by the cost of goods sold, whereas FIFO shows it by the cost of goods unsold.
- Restrictions: LIFO is restricted by IFRS, whereas FIFO has no restrictions.
- Inflation: LIFO represents the low-income tax amount since the profit margin is low, whereas FIFO represents the high-income tax amount since the profit margin is high.
- Deflation: The scenario becomes the exact opposite in deflation, where LIFO pays a higher return and FIFO pays a lower one.
How to Switch to LIFO
All the inventory methods mentioned above are different from one another. Each has its own rules and regulations to carry out the process. If you already practice any one of the inventory methods, say FIFO, then it would significantly impact your business to switch to LIFO mode.
It is important to note that ‘LIFO Profit’ depends on the country’s economy. If inflation is happening in your country, you will sell out the expensive materials first, increasing your COGS value by going by the LIFO inventory method. Between high COGS and the high price of goods, you have a little profit margin left for yourself. But simultaneously, you’ll have to pay less tax for your business.
On the other hand, if deflation happens in your country, the case would be the opposite. Therefore, only those firms which have been in the business for quite a few years operate the LIFO method. They can handle this risky method brilliantly, giving them good results.
To maintain consistency in your business, the laws (for instance, IRS) require legal approval for using the LIFO method. It means sellers must incorporate the LIFO method right from the beginning of their business. It has to be present in your financial records, apart from the tax returns.
If you change your method to LIFO, you must inform the IRS before implementing it.
If you’re new to the business, you are advised to do thorough research and use the FIFO method to avoid risks.
Industries that use FIFO
Groceries– Businesses that sell grocery or daily-use items use the FIFO method to sell out old products first.
Perishable items– FIFO is the best method for those retailers who sell perishable items. These could be beauty products, food items, etc.
New businesses– As mentioned above, FIFO is the less risky method to implement. It goes with the flow and is the easiest to calculate. You can also view it as a “by default setting” where you must follow the lead.
Industries that use LIFO
Businesses in the market for quite some time use the LIFO method. One of the main reasons is their mastery of calculating risks. Industries that use LIFO are-
- Pharmaceutical Industries
- Oil and Petroleum Industries
- Automotive industries
Problems related to FIFO
The only problem with FIFO is at the time of inflation. During inflation, the cost of products increases which implements only the newest items present in the stock. However, since FIFO rolls out the oldest products first, the price remains affordable, showing higher net income. High net income thereby triggers the tax return that could create fuss among entrepreneurs.
Hyperinflation also creates obstacles for FIFO since the prices of products increase rapidly, but it is of little or no use to business owners because of the low prices of old ones.
Problems Related to the LIFO Method
Several problems with the LIFO method make it less practical for businesses to carry out. Some critical problems associated with LIFO are as follows.
As you may have noticed before, a decrease in the price of commodities could lead to some adverse effects on the business. It happens because LIFO follows the ‘latest first’ tradition. It refers to the more expensive goods that are sold out first. In some industries, prices are not specific and predictable, especially in the case of volatile prices of commodities. Therefore, at the time of deflation, the LIFO mostly suffers.
In the LIFO methodology, at least one portion of the inventory we valued under LIFO is priced at the company’s early purchase prices. LIFO liquidation happens when the company sells more items than it purchased in a year. Hence, the LIFO layers that were built in the past are liquidated.
Firms can often plan out the LIFO liquidation events, but this sometimes has the potential to go out of control. For instance, any unpredictable activity or demand from the supplier can cause unplanned LIFO liquidation.
The LIFO inventory method gives plenty of space to the management to manipulate the profits generated by the end of the year. If you look at this from the management perspective, it won’t be problematic. However, for the critics, this could lead to disadvantages for LIFO.
In some places or systems, such as International Financial Reporting Standards (IFRS), the LIFO method is incompatible. In some countries, the LIFO method is allowed as the financial statements can be manipulated in the company’s favor.
The profit margin from the LIFO system is highly dependent on the country’s economy. As mentioned above, the inflation and deflation rate decides how much profit the entrepreneurs will earn.
What is LIFO Reserve?
LIFO reserve can be seen as a bridge between FIFO and LIFO. It measures the difference between the cost of inventory of FIFO and LIFO. A company uses LIFO reserve when it uses FIFO to maintain the tract of the merchandise but reports under the LIFO method to prepare financial statements.
LIFO reserve comes into play when the company uses FIFO (standard cost method) for internal use and uses LIFO for external reporting for tax preparation purposes. This could be a plus point at times of rising prices. It lessens the company’s tax burden when the reports show the LIFO method.
Calculating LIFO reserves
The simple way to calculate LIFO reserves is by subtracting your FIFO inventory from LIFO inventory.
LIFO reserve= FIFO inventory- LIFO inventory
To ensure accuracy, the LIFO reserve is tracked so that the companies that use different accounting methods can be compared accurately. LIFO reserve is a perfect method to conduct this procedure.
Nowadays, replacements such as ‘revaluation to LIFO’, ‘ec=xcess of FIFO over LIFO’, or ‘LIFO allowance’ are used instead of LIFO reserve.
Benefits of LIFO reserves
As mentioned above, LIFO reserve is the best way for investors to ensure the accuracy between two different accounting methods. It allows the investor to get a clear picture of the differences between their two approaches and how they might impact their taxes.
It also allows the company to adjust its financial statements related to sales, costs, taxes, and profits.