When it comes to FIFO vs LIFO, and assessing which method is better for inventory valuation, businesses find it difficult to choose the right one. These are the two most common approaches to inventory valuation. FIFO, which stands for 'First-In, First-Out', assumes that the first items to enter your inventory are also the first items you sell. Also known as 'Last-In, First-Out', LIFO assumes that the most recently added items to your inventory will be the ones that sell first.
The stock valuation technique you pick will rely upon your assessment circumstance, stock stream, and recordkeeping prerequisites. Read this informative article and opt for the method best suiting your business!
What Is the Difference Between LIFO and FIFO?
First-in, First-Out, and Last-In, First-Out are two common inventory accounting methods relied on by businesses to track and manage their inventory, and the cost of goods sold.
Since the LIFO or the Last-In, First-Out method assumes that the most recently purchased or produced inventory items are sold first, it leads to the valuation of the cost of the goods sold (COGS) based on the most recent inventory costs, which are usually higher due to inflation or other factors. This results in lower profits and lower taxes during inflation, as the cost of goods sold is higher. As a result, this may ultimately reduce the taxable income.
On the other side, FIFO or First-In, First-Out method assumes that the oldest inventory items purchased or produced are sold first. Due to this, the COGS is based on the oldest inventory purchases or production costs, which are usually lower. This results in higher profits and higher taxes in times of inflation, as the cost of goods sold is lower, increasing the taxable income.
This is the key difference between both methods. However, the final assessment of both LIFO FIFO methods is considered to be subjective. The methods are only linked to inventory totals and not actual inventory tracking. It implies that a business employing the FIFO method may sell the inventory acquired more recently first, and vice versa with the LIFO method. However, both approaches must assume that inventory is being sold in their intended orders to calculate the cost of goods sold accordingly.
FIFO and LIFO Examples
We will use the example of a single business to show how to calculate the cost of goods sold using the FIFO and LIFO methods of inventory valuation.
FIFO vs LIFO example: DXY is a business that has been operating for a year now. Their inventory costs appear as follows:
| Month | Amount | Price Paid ( in Rs.) |
|---|---|---|
| January | 10 Units | 100 |
| February | 10 Units | 100 |
| March | 10 Units | 100 |
| April | 10 Units | 100 |
| May | 10 Units | 150 |
| June | 10 Units | 150 |
| July | 10 Units | 150 |
| August | 10 Units | 150 |
| September | 20 Units | 300 |
| October | 20 Units | 300 |
| November | 20 Units | 300 |
| December | 20 Units | 300 |
Units Acquired = 180 Units = Chocolate
It is assumed that the unit cost of chocolate consistently increased. Assuming that DXY maintained the same sales prices (which the company did to remain competitive), i.e. Rs. 350, this implies there was less benefit for DXY's chocolate before the year ended.
For the year, the unit of chocolate sold was 120. Total Sale = 350 Rs. X 120 units = Rs. 42000
Let's calculate the cost of goods sold using the LIFO and FIFO methods of inventory valuation.
The FIFO method of inventory valuation:
DXY must use the older costs of acquiring his inventory according to the FIFO method and proceed from there.
So DXY's COGS calculation is as follows:
40 units X 100 Rs. = 4000 Rs.
40 units X 150 Rs. = 6000 Rs.
40 units X 300 Rs. = 12000 Rs. Total = 22000 Rs.
DXY's cost of goods sold is Rs. 22000.
The LIFO method of inventory valuation:
DXY must start with its most recent inventory costs and work backward using the LIFO method.
80 units X 300 Rs. = Rs. 24000
40 units X 150 Rs. = 6000 Rs. Total = Rs. 30000
DXY's cost of goods sold is Rs. 30000.
Between FIFO vs LIFO, it's easy to see see how the LIFO approach generates a higher inventory cost, lower profits, and consequently fewer taxes to pay during the end of the financial year.
In this example of LIFO vs FIFO inventory valuation, Rs. 8000 serves as the LIFO reserve. When compared with the FIFO technique, the LIFO hold is the sum by which an organization's available pay has been increased. The 'inventory' will account for the 60 remaining chocolate units that have not been sold.
Advantages and Disadvantages of Using FIFO and LIFO
Below are FIFO vs LIFO advantages and disadvantages:
LIFO vs FIFO Advantages
LIFO
Companies that use the last in, first out method benefit from a tax break because it assumes it will sell the recently acquired inventory first. LIFO results in a lower balance of leftover inventory and a higher cost of goods sold as inflation continues to rise. Due to LIFO's lower net income, the higher cost of goods sold results in a smaller tax liability.
FIFO
Using FIFO in your warehouse solves the problem of dealing with fluctuating inventory costs, which is one of its most significant advantages. Your inventory bottom line will more likely approximate the current market value if you use FIFO. Your business will discover that your first deducted inventory costs are the oldest unit costs and that your assumed flow of costs matches the normal physical flow of goods. The FIFO method makes application and recognition easy while restricting inventory manipulation by auto-selecting which unit to ship.
LIFO vs FIFO Disadvantages:
LIFO
As older inventory may never be shipped or sold, LIFO is more challenging to maintain than FIFO. Because the costs of unsold inventory remain in the accounting system, LIFO also results in more complicated records and accounting procedures. LIFO is not a good idea if you have perishable goods because they may run out on the shelf before they are sold or shipped. Additionally, popular international accounting standards prohibit LIFO valuation, making it unsuitable for businesses expanding globally.
FIFO:
The FIFO method can give an impression that your business has a greater cashflow than it does because prices have continuously increased for years. Naturally, if FIFO is utilized during periods of inflation, this larger-than-life profit results in a greater burden on taxpayers. One must note that the FIFO valuation method does lead to higher taxes which reduce the business' cashflows and future revenue.
Which Method Is Better: FIFO or LIFO?
We have listed out key details to assist you in selecting the most suitable option between FIFO vs LIFO for your business.
1. Costs Rising vs Decreasing:
To evaluate the general worth of LIFO and FIFO techniques for stock valuation, you need to take a look at how your stock expenses are evolving.
LIFO costing may be preferable if your inventory costs are rising or likely to rise because the more expensive items-purchased or made last-are considered to be sold. As a result, costs rise, and profits are reduced. FIFO costing may be preferable if the opposite is true and your inventory costs decrease. However, most businesses prefer to use LIFO costing because prices typically rise.
2. Requirements for Recordkeeping:
FIFO, where older inventory items are sold first, requires less recordkeeping. In comparison, LIFO inventory accounting requires more recordkeeping because it assumes the company will keep the older inventory items on hand for several years.
3. Accuracy of Counting:
FIFO is better when it comes to comparing FIFO and LIFO accounting methods as it is more accurate because it assumes that older, less expensive items are typically sold first.
4. Selling Globally:
If you do business internationally, you must use FIFO because the International Financial Reporting Standards (IFRS) do not permit LIFO inventory.
How Do You Calculate FIFO and LIFO?
To determine your gross profit margin, use the following formula:
Gross profit margin = Total sales - Cost of goods sold
Values are taken from above LIFO vs FIFO Examples
From the LIFO method of inventory valuation:
Gross profit margin = Rs. (42,000 - 30,000) = Rs. 12,000
With the FIFO method of inventory valuation:
Gross profit margin = Rs. (42,000 - 22,000) = Rs. 20,000
It exemplifies the impact of employing the LIFO strategy during a time of rising prices. The gross profit margin with LIFO Rs. 12,000, is less than Rs. 20,000 when FIFO is used. As a result, the business reports lower profits and incurs fewer taxes.
Selecting the right inventory valuation method is key to ensuring profitability in businesses, therefore, ensure your inventory software facilitates compliance with accepted inventory accounting methods.
Implementing FIFO or LIFO in your business
Although seemingly complex, when followed accurately, FIFO and LIFO are extremely simple to implement. In addition, modern inventory and point of sales (POS) systems will have features for tracking and valuing inventory seamlessly, making it simple for managers and owners of businesses to choose between LIFO and FIFO and use their preferred method.
An inventory management tool can help you in comparing the effects of the First-In, First-Out, and Last-In, First-Out method on your bottom line if you are unsure of which method is better for your business. Having said that, you should note that LIFO is becoming increasingly uncommon because some accounting standards prohibit it.
Naturally, deciding between LIFO vs FIFO is not a one-time decision. You can always switch to different methods of inventory valuation, even if you've been using one or the other for years; however, you should consult an accounting and taxation expert during this process who will help you in assessing LIFO FIFO problems with solutions.
Simplifying the Choice of the Right Inventory Management Tool
While tax implications are not the only determining factor when choosing between FIFO and LIFO inventory valuation methods, they should play a significant role in your decision. Professional solutions like TranZact can make your inventory valuation process smooth and easier by tracking inventory movements in real-time. TranZact also provides insightful inventory analysis with smart business dashboards for quick decision-making for business owners.
FAQs on FIFO vs LIFO
1. What is the difference between FIFO and LIFO inventory management methods?
The First-In, First-Out (FIFO) strategy assumes that the first unit of inventory to be sold is the oldest. On the other hand, the Last-In, First-Out (LIFO) strategy is based on the assumption that the first unit to be sold is the one that arrives in inventory the earliest.
2. What are the advantages of using the FIFO inventory management method?
By using older inventory before using newer inventory, FIFO helps prevent obsolete inventory concerns. As the items in the company's inventory that are the oldest are used first, FIFO lessens the impact of inflation on the business.
3. What are the disadvantages of using the FIFO inventory management method?
FIFO assumes that the oldest items in inventory are sold first, which means that the cost of goods sold is based on the higher cost of those older items. This can result in inflated profits and an inaccurate representation of the current cost of goods sold.
4. What are the advantages of using the LIFO inventory management method?
LIFO results in a lower balance of leftover inventory and a higher cost of goods sold. Due to LIFO's lower net income, the higher cost of goods sold results in a smaller tax liability.
5. What are the disadvantages of using the LIFO inventory management method?
Using the LIFO method can result in lower taxable income due to the assumption of lower costs of goods sold, which can lead to a lower tax liability for the company. However, this can also result in higher tax payments in the future if the company's inventory costs increase.
6. How do you choose between FIFO and LIFO inventory management methods?
Choosing between FIFO and LIFO inventory management methods depends on various factors, including the nature of the business, the industry, and the company's financial goals. If a company wants to reflect the current cost of goods sold accurately, it may choose the FIFO method as it assumes that the oldest items in inventory are sold first. However, if the company wants to reduce the carrying cost of inventory and reflect the current market value of inventory, it may choose the LIFO method.
7. What are some examples of industries that use FIFO and LIFO inventory management methods?
Food, medicine, and cosmetics are the most common categories of perishable goods for which the FIFO method is used. On the other hand, the LIFO method is typically used to manage non-perishable goods with no or long expiration dates, such as those used by automotive or petroleum-based industries.
8. What are the criticisms of FIFO and LIFO inventory management methods?
Both FIFO and LIFO methods can be complex and require detailed record-keeping, which can be time-consuming and costly. Companies may switch between FIFO and LIFO methods to manipulate their financial statements, making it difficult for investors and other stakeholders to compare financial performance over time.
9. What are some alternative inventory management methods?
When it comes to FIFO vs LIFO vs weighted average method, the weighted average method calculates the average cost of all items in inventory and uses that cost to determine the cost of goods sold and the value of the ending inventory. The advantages of using weighted averages include a simple calculation process and a smooth inventory valuation. However, it can lead to distorted financial statements if there are significant fluctuations in the cost of goods purchased.
