The inventory valuation process is very important in accounting. It enables the company to calculate the goods sold and the cost of the remaining inventory.
There are two most popular methods in accounting: FIFO and LIFO. Each method has unique characteristics. But which one to choose so it would benefit your business? Keep reading to get a better understanding.
FIFO stands for the “first-in, first-out” method. It is used to calculate and manage assets. According to the FIFO method, units that were produced or purchased first are also sold, used, or disposed of first.
In accounting and for tax filing purposes, it is assumed that items with the oldest costs should be added to the income statement COGS (or COG) – the cost of goods section. All other items from the inventory have to be matched with items a company has sold or produced in the most recent period.
The goal of using FIFO is to measure assumed cost flow. When it comes to producing goods or materials, items progress to other development phases, and all associated costs are considered as expenses.
The same rule is applied to selling assets from the inventory, so the company first recognizes the costs of the first bought inventory. The value of the entire inventory decreases as certain inventory parts are sold. Businesses use the FIFO method to calculate costs associated with selling or maintaining the inventory.
The method considers such situations as rising costs and inflationary markets. According to FIFO, an accountant has to assign the oldest prices to the cost of goods sold. The oldest prices are typically lower than the price of the most recent inventory, which was purchased at a lower inflated price.
This means that the business spends less money (because of the inflation) on acquiring the new inventory; therefore, it gets a higher net income. But since the business purchased the newest inventory at a higher price because of inflation, the end inventory balance is also inflated.
The best way to explain how to calculate COGS by using the FIFO method is to use an example. Let’s assume there is a company called PhoneCases selling phone cases. The company uses the services of a local vendor that sells cases for $5 per unit.
At the beginning of January, the case per unit was $5, and the manager of PhoneCases ordered 100 cases. But during that January, the vendor decided to raise the price per unit to $6. The manager had to order an additional 200 cases at $6 per item, and the company had the remaining 100 at $5 per item.
Closer to the end of January, the company has sold 250 cases. According to FIFO, the company sold the older inventory first, so the accountant should calculate the remainder of the inventory due to the recent cost.
Overall, PhoneCases has 300 cases, so the remainder is 50 cases at a price of $6 per unit. Now let’s calculate COGS and inventory value:
- Cost of goods sold (COGS) for January is $1,400 ((100 x 5) + (150 x 6))
- The remaining inventory is calculated according to the idea that the first inventory was sold first, then it’s the older inventory’s turn. This means that cases in the inventory cost $6 per unit. Only 50 cases are left, so the inventory cost is $300 (50 x 6).
GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) consider this method accurate. However, the FIFO cash flow assumption method may not represent the actual sales pattern.
LIFO stands for the “last in, last out” accounting method of calculating the inventory. According to LIFO, the last or the most recent items produced or purchased are the ones to be sold first.
This system offers an opposite approach to the one offered by FIFO. According to LIFO, when calculating COGS, the accountants have first to consider the most recent items companies purchase or produce. Only then do they consider older units. So, the accountant should calculate the inventory according to the oldest (first) price.
Note, last in, first out is mainly popular in the United States and approved by GAAP. The International Financial Reporting Standards doesn’t recognize LIFO and forbids its usage.
LIFO inventory calculation method is popular among companies with bigger inventories and higher cash flows. If your business is related to retail or auto dealerships, it’s a good idea to use LIFO as it lowers taxes when prices are rising.
Let’s again use the example to show how the LIFO method works. Let’s assume there is a company called ExampleBusiness that works in retail.
ExampleBusiness orders the first 500 pairs of jeans at the cost of $20 per unit. The order was done and added to the inventory two weeks ago. Then ExampleBusiness ordered another 300 pairs of jeans at the cost of $25 per unit, and the order arrived today. It’s the entire order of one item during May.
According to LIFO, the last units to add to the inventory are the first to sell. In May, the company sold 700 units. So, what is the cost of goods sold and the value of remaining inventory under the LIFO method?
Accountants have to record those 300 units as sold first and then 400 units that were added to the inventory. Keep in mind that the company sells each pair of jeans for the same sales price, and the revenue doesn’t change. Here is the calculation:
- The cost of goods sold is $15,500 ((300 x 25) + (400 x 20)).
- ExampleBusiness still has 100 more units as the inventory, so its value is $2,000 (100 x 20).
Let’s compare LIFO to FIFO. If the company uses FIFO instead of LIFO, then the cost of goods sold would be $15000 ((500 x 20) + (200 x 25)). And the value of the inventory is $2,500 (100 x 25).
This difference is the main reason why some companies prefer LIFO. When prices are rising and thus lower the revenue, LIFO reduces taxable income. When prices are decreasing and revenue is higher, LIFO increases taxable income.
FIFO vs. LIFO
Each method has peculiarities, advantages, and disadvantages. Different businesses prefer one of two methods based on the industry and other factors. Let’s see what the differences are between FIFO and LIFO when calculating the inventory’s valuation and its impact on the cost of goods sold and revenue.
The first method may be a better option to evaluate the ending inventory. Older units are always the ones to be sold or produced first, and the most recent units reflect current market costs.
Most businesses consider FIFO as the obvious option since they sell or produce items acquired in the first place. Thus, FIFO evaluates COGS and reflects their production or sales schedule.
Let’s see an example. A business is selling seafood products. It uses the first acquired inventory to produce seafood products to avoid stock spoiling. That’s why the FIFO method accurately reflects a business’s production schedule.
According to LIFO, businesses use the most recently acquired stock to value COGS. The remaining inventory can get extremely old or even obsolete. Because of this peculiarity, LIFO can’t provide an accurate and updated inventory estimation. The inventory’s value is significantly lower compared to current prices.
Most companies prefer FIFO because of the mentioned example. It’s unrealistic for companies that produce food or use materials that spoil over time to consider LIFO.
As in the previous example, a seafood company would not use LIFO since it obviously uses the oldest acquired inventory to produce quality food. Otherwise, it wouldn’t be realistic for the company to claim that they use the most recent products and let the oldest inventory be spoiled, leading to loss.
So, what method should you choose? If you have a business related to producing foods, it’s unrealistic to use LIFO. It won’t reflect the logical production process. Materials will spoil if the business uses the most recent products.
But if a company has a bigger inventory or high cash flow, and isn’t related to producing foods, it might be a good idea to consider LIFO.
Author: Charles Lutwidge