Inventory is one of the essential elements in a company’s balance sheet. Therefore investors must understand the different methods available for assessing the same while comparing companies across various industries or even within their portfolios. This is where LIFO and FIFO come into play.
LIFO and FIFO are two common methods for assessing a business’s inventory value. However, it is essential to remember that LIFO and FIFO are only responsible for the inventory totals and not for keeping track of physical inventory. Let’s explore everything there is to know about the two methods and LIFO vs. FIFO.
What Is Inventory?
Before diving deeper into the two methods of accounting mentioned above, let’s take a look at the basics first. So what exactly does an inventory mean? To put it simply, inventory refers to a company’s goods in three stages of production. It includes goods that are raw materials, those already in production, and in the final stage, the finished goods that are ready for sale.
But why is inventory so crucial for any business? This is because companies must list all their assets, including inventory while preparing financial statements. So, it is essential to calculate the inventory value correctly to list them on the financial statements. Furthermore, inventory valuation helps a business make well-informed purchase decisions and understand inventory turnover trends and ratios. First in, first out (FIFO), and last in, first out (LIFO) are two well-known inventory valuation techniques.
The mentioned below articles talks in detail about the specifications of LIFO and FIFO, and how to calculate LIFO and FIFO
What is FIFO? How Does it Work?
The inventory valuation method that a company uses can directly impact the financial statements of any business. So understanding the various techniques available is crucial for any business to sustain itself in the long run. FIFO, also known as First In First Out, is one of the most trusted methods of calculating the cost of goods sold.
But what exactly does it mean? As the name suggests itself, FIFO refers to the method wherein the first unit of inventory, or the oldest unit, gets sold first, followed by the latter ones. This means that the fresh stocks will stay in the inventory unless the stock purchased earlier is not exhausted. This, in turn, helps business owners cut waste and generate higher profits.
How to Calculate FIFO
To find out the cost of goods sold, using the FIFO method, you need to first calculate the cost of your oldest stock and then multiply the number by the amount of inventory that has already been sold.
Example of FIFO
To help you understand this method better, mentioned below is a simple example of the same.
Suppose a company has paid $1000 for 100 items, which means each item costs $10. The same company then purchased 100 more items for $15 each. However, the company was only able to sell 60 items. So if you want to calculate using the FIFO method, the cost of goods sold is $10 per unit because the first goods purchased are the first ones to be sold, followed by the newer ones.
What is LIFO? How Does it Work?
LIFO, also called Last In First Out, is yet another valuation method that various companies across different industries use. It is the opposite of FIFO, which means that the last batch of items bought is the first to be sold out. Although it does help the consumers to get the freshest products, the companies using this method might have to bear certain losses that can significantly impact the financial statements.
How to Calculate LIFO
Contrary to FIFO, to find out the exact cost of goods sold, using the LIFO method, you need to find out the cost of your most recent inventory and then multiply that number by the cost of the number of products sold.
Example of LIFO
Let’s say that a company purchases 200 loaves of bread for $1 each on one day, and on the next day, the same company purchases another 200 loaves of bread for $1.25 each. On the third day, the company sold only 200 loaves of bread. So if you want to calculate the cost using LIFO, it would mean that the cost of goods sold is $1.25 each since the latest stock is the first to be sold to the customers.
Restrictions On The Use Of LIFO
Unfortunately, under the International Financial Reporting Standards (IFRS) guidelines, LIFO has been banned since it can cause potential distortions to a company’s financial statements.
How Do FIFO and LIFO Differ?
Now that you understand these utterly different inventory management techniques, let’s dive deeper into the key points that differentiate these methods.
Products
As mentioned, FIFO considers the oldest stocks the first ones to be sold out, whereas the customer gets the newest arrivals. Companies involved in easily perishable product services can benefit from using the FIFO technique. This is because, when the product’s price remains steady in the market, this method can help a business owner eliminate any increase or reduction in prices for the newer units.
Whereas, if a company deals with products that are not harmed or affected by the amount of time spent in the inventory, then following the LIFO technique is preferable.
Accounting Calculations
Under LIFO, the costs of the recently purchased or produced products are the first that they expense.
Contrary to this, FIFO assumes that all the oldest goods are the first ones they’ll sell. This means that the latest items they stock up in the inventory are the first ones they ship to the customers instead of the older ones.
Tax Purposes
FIFO helps a company value the cost of goods at a lower price, leading to higher profits and taxes.
LIFO, on the other hand, results in lower profit and tax since the cost of goods is generally higher. Various companies use this method to take tax advantage.
Flow Of Goods
The FIFO technique offers companies a clear and transparent view of the inventory’s in and outflow of goods. Many companies prefer this method since it helps to eliminate excess waste or spoilage of materials. On the other hand, LIFO is more suitable for coal and natural gas industries since the most recently acquired stock gets out first to the customers.
Inventory
Following the LIFO technique for inventory management keeps the newer items in focus, assuming that the older stock can remain in the inventory for a long time without any potential damage. However, there is one threat that accompanies this method, which is it minimizes the inventory write-downs when the market value of the goods decreases. On the other hand, FIFO assumes that the older stocks are continually getting sold out, and new supplies fill the gap.
Which is the best inventory valuation method- FIFO Vs LIFO for your business?
It is not an obligation for any company to follow a particular inventory management method till the end. This means that businesses always have the liberty to change their management techniques per their company’s needs and wants. However, the process can be somewhat complicated at times, so it is recommended to seek the guidance of a CPA during this transition period.
To help you better understand, here is a list containing both the advantages and disadvantages of these two methods.
FIFO Vs. LIFO: Advantages and Disadvantages
Advantages of FIFO
- It is one of the most trusted and universally accepted inventory management methods.
- It helps a company to generate less waste since they will ship out all the older products first, as per the guidelines of this method.
- It generates higher profitable outcomes.
- It reduces the chances of distortions in financial statements.
Disadvantages of FIFO
In certain situations, FIFO might result in higher income tax for a business since the gap between the cost and profit is generally much higher than with LIFO. Furthermore, companies following this method also need to be extra careful about their profit and ensure they are not overstating the same.
Advantages of LIFO
- Helps to reduce the understatement of the cost of goods sold and the overstatement of profit.
- The quality and reliability of the earnings automatically increase using LIFO.
- Generates a lesser income tax result to improve the overall cash flow of a company.
- Automatically reduces the chances of write-downs in the market.
Disadvantages of LIFO
- This can lead to reduced reported earnings, especially during periods of inflation.
- High chance of understatement of balance sheet inventory since it relies heavily on the older costs.
- Can cause disturbances and manipulation of the reported earnings
As quite visible, both of these techniques have their pros and cons. Based on the kind of products and goods your company deals with, you can choose any of the above accordingly. If you are still facing difficulties, you always have the option to select an inventory management tool, to help understand the impact of LIFO and FIFO on your bottom line.
Conclusion
Other than LIFO and FIFO, there are also various other inventory management methods available that you can choose from for your business. One such might include yet another popular way, which is dollar-cost averaging.
Choosing a method for your inventory management might seem relatively trivial at first. However, the subtle differences between LIFO and FIFO can result in vast amounts of tax savings per year. Therefore, as a business owner, it is imperative to keep track of your inventory, especially when implementing an inventory management method, to generate the maximum profit and significantly reduce your tax burden from sales.
FAQs
Is inventory turnover higher with LIFO or FIFO?
If used during a period of increased costs, or inflation, the inventory turnover ratio is usually greater with LIFO. This is because using LIFO results in a higher cost of goods sold and a lower inventory cost than FIFO.
Why is LIFO not recommended?
The IFRS guidelines banned the LIFO method due to its potential risk of altering or distorting a company’s financial and profitability statement. An example to substantiate this claim might include that LIFO can quite easily understate a company’s earnings to keep income tax low.
When is the LIFO method most suitable?
Companies can reap potential benefits using the LIFO cost accounting method, especially during rising prices. With the help of LIFO, business owners can save up on taxes and match their revenues to the latest costs in a much more efficient manner.
What kinds of companies use FIFO?
Companies that sell perishable goods and items mostly prefer FIFO technique. This might include commodities such as food and flowers. The reason is that under the FIFO method, the oldest stocks are the first to be sold out. Therefore, companies can essentially reduce their loss. This also holds true, especially for other companies that deal with international business or report to foreign countries for tax purposes.
When should a company use FIFO?
Companies generally use FIFO for cost flow assumption purposes. During the manufacturing process, as more and more items slowly move towards the final development stage, ready to be sold out, the associated costs that come along with the products are written down as expenses.
Which one is more accurate: LIFO or FIFO?
FIFO is generally considered the more logical choice by most companies since it first uses the oldest inventory in producing goods. On the other hand, many enterprises do not prefer LIFO since companies would not leave their old inventory sitting idle in stock.
