FIFO vs LIFO: How to Pick an Inventory Valuation Method

FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this results in higher tax liabilities and potentially higher future write-offs if that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory. Under the LIFO method, assuming a period of rising prices, the most expensive items are sold. This means the value of inventory is minimized and the value of cost of goods sold is increased.

If you plan to do business outside of the U.S., choose FIFO or another inventory valuation method instead. FIFO will have a higher ending inventory value and lower cost of goods sold credits and deductions for individuals (COGS) compared to LIFO in a period of rising prices. Therefore, under these circumstances, FIFO would produce a higher gross profit and, similarly, a higher income tax expense.

• This difference is known as the “LIFO reserve.” It’s calculated between the cost of goods sold under LIFO and FIFO.
• When you sell the newer, more expensive items first, the financial impact is different, which you can see in our calculations of FIFO & LIFO later in this post.
• The store purchased shirts on March 5th and March 15th and sold some of the inventory on March 25th.
• Although this may mean less tax for a company to pay under LIFO, it also means stated profits with FIFO are much more accurate because older inventory reflects the actual costs of that inventory.
• In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
• By contrast, the inventory purchased in more recent periods is cheaper than those purchased earlier (i.e. older inventory costs are more expensive).

Inventory costing remains a critical component in managing a business’ finances. The average cost is a third accounting method that calculates inventory cost as the total cost of inventory divided by total units purchased. Most businesses use either FIFO or LIFO, and sole proprietors typically use average cost.

How do FIFO and LIFO affect more straightforward accounting operations?

When a business uses FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold. FIFO stands for First In First Out and is an inventory costing method where goods placed first in an inventory are sold first.

LIFO, also known as “last in, first out,” assumes the most recent items entered into your inventory will be the ones to sell first. The inventory valuation method you choose will depend on your tax situation, inventory flow and record keeping requirements. 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. In sum, using the LIFO method generally results in a higher cost of goods sold and smaller net profit on the balance sheet.

LIFO and FIFO: Advantages and Disadvantages

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. We’ll explore how both methods work and how they differ to help you determine the best inventory valuation method for your business. Use QuickBooks Enterprise to account for inventory using less time and with more accuracy.

The costs included for manufacturers, however, are different from the costs for retailers and wholesalers. You also need to understand the regulatory and tax issues related to inventory valuation.FIFO is the more straightforward method to use, and most businesses stick with the FIFO method. The LIFO method requires advanced accounting software and is more difficult to track. You’ll spend less time on inventory accounting, and your financial statements will be easier to produce and understand.

Unique Features of FIFO

On their accounting reports, they can calculate a higher cost of goods sold and then report less profit on their taxes. FIFO and LIFO inventory valuations differ because each method makes a different assumption about the units sold. To understand FIFO vs. LIFO flow of inventory, you need to visualize inventory items sitting on the shelf, each with a cost assigned to it.

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The newer units with a cost of $54 remaining in ending inventory, which has a balance of (130 units X $54), or $7,020. The sum of $6,080 cost of goods sold and $7,020 ending inventory is $13,100, the total inventory cost. In this case, the store sells 100 of the $50 units and 20 of the $54 units, and the cost of goods sold totals $6,080.

Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. You also need to remember that you need special permission from the IRS in order to use the LIFO method, and if you do business internationally, you cannot use LIFO at all. Using the following example, we’ll be able to see how LIFO and FIFO affect the cost of goods sold and net income.

When you sell the newer, more expensive items first, the financial impact is different, which you can see in our calculations of FIFO & LIFO later in this post. For example, the seafood company, mentioned earlier, would use their oldest inventory first (or first in) in selling and shipping their products. Since the seafood company would never leave older inventory in stock to spoil, FIFO accurately reflects the company’s process of using the oldest inventory first in selling their goods. For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products.

Example of FIFO and LIFO accounting

When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from a lower tax liability. The decision to use LIFO vs. FIFO is complicated, and each business situation is different.

POS sales reports can help you make informed inventory decisions and compare sales from different store locations. 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.