FIFO and LIFO are two accounting methods used to assess inventory costs. FIFO stands for "first in, first out." LIFO is an acronym for "last in, first out."
FIFO and LIFO determine how you value your company's inventory and calculate your cost of goods sold (COGS). They differ in how they assume inventory flows in and out of your company.
Here's how to determine which approach is right for your business and how to use FIFO and LIFO compliantly.
How does FIFO work?
The first-in, first-out method assumes that the oldest items in your inventory are sold first. The COGS calculation, therefore, uses the cost of your oldest inventory multiplied by the total amount sold to come up with a number.
FIFO is generally the most common approach to inventory accounting. "FIFO is generally accepted as the more accurate inventory valuation system," wrote FreshBooks. "Regular inventory turnover tends to keep inventory value closer to market value and is a more realistic representation of how most companies move their products."
How is LIFO calculated?
Last in, first out uses the costs of the most recent inventory as the baseline for calculating COGS. It assumes that the newest inventory is sold first.
Some business owners use the LIFO approach because inventory costs usually rise over time, eating into the company's profit margins. LIFO accounting allows the company to pay lower taxes as a result. However, to get an accurate read on the company's profits, LIFO isn't the ideal option.
"Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete," wrote Investopedia. "As a result, LIFO doesn't provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today's prices."
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Should your business use LIFO or FIFO?
Most businesses benefit from using the FIFO calculation. It's easy to use, accepted, and trusted by investors, lenders, and the IRS, and it follows the natural physical flow of inventory. FIFO is the right choice, especially for businesses that deal in perishable goods, such as restaurants.
LIFO is only permitted as one of the Generally Accepted Accounting Principles (GAAP) in the United States. International companies can't use LIFO as an accounting practice.
"[The] LIFO approach tends to understate the value of the closing stock and overstate COGS, which is not accepted by most taxation authorities. If a company uses the LIFO method, it will need to prepare separate calculations, which calls for additional resources,” wrote the Corporate Finance Institute.
LIFO is favored by companies that are seeking to attract investors since lower taxable income from LIFO translates to a lower tax liability. This can improve a company's cash flow, a key metric that investors will look at when determining whether to commit funding.
LIFO is also the preferred option during periods of inflation. The COGS is higher since LIFO assumes the most recent, presumably more expensive inventory is sold first. This results in a lower taxable income for the company.
Note that if you decide to use the LIFO method, you’ll need to file an official application with the IRS to use that method.
A third option: Average cost
The average inventory method offers a middle ground between LIFO and FIFO. In this approach, take the weighted average of all units available for sale during the accounting period. Then, use that average cost to determine the value of COGS and ending inventory.
If FIFO results in the highest net income and LIFO is the lowest, the average inventory method lands somewhere between these two figures. However, this method is more time-consuming to calculate, and during inflation, the average cost method might not accurately reflect the current replacement cost of inventory. This can impact the valuation of ending inventory and COGS.
Ultimately, the decision between LIFO and FIFO depends on a company's specific circumstances and its financial goals. It's always best to consult with a tax adviser or accountant to determine the most suitable method.
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The way a company values its inventory directly affects its cost of goods sold (COGS), gross income, and the monetary value of inventory remaining at the end of each period.Abby Jenkins, Oracle NetSuite
When to switch between FIFO, LIFO, and average cost
It is possible to change your inventory costing method, with some restrictions. The IRS requires that you stick to one inventory cost method for the first year you file your business tax return. Thereafter, you can change your inventory cost method by notifying the IRS to get permission for the tax year when you implement your new method. Complete IRS Form 3115 and send it with your tax return.
Generally speaking, it’s not recommended to switch between accounting methods more than once. Consistency is fundamental to the GAAP, and changing your accounting method can lead to mistakes.
There are a few moments in your business lifecycle when changing inventory costing methods is the right move. For instance, if you experience a drastic change in inventory, like an overseas expansion or a big increase in bulk shipments. Rapid expansions can also lead to the need for a change.
"As you set up the new method, structure it clearly with organised documents. Make sure you note where and when you switched methods. Outline your new approach and create a plan for how you’ll update and calculate it day-to-day," wrote Countingup, a small business banking app.
How inventory valuation affects your taxes and profit
The inventory accounting method you choose can impact your gross profit as well as your taxes.
"The way a company values its inventory directly affects its cost of goods sold (COGS), gross income, and the monetary value of inventory remaining at the end of each period," wrote Oracle NetSuite. "Therefore, inventory valuation affects the profitability of a company and its potential value, as presented in its financial statements."
The COGS equation is Beginning inventory + Purchases – Ending inventory. FIFO generally results in a lower COGS and higher gross income than other valuation methods. Here’s an example to illustrate the difference between LIFO and FIFO.
Let's say you sell phone cases and make the following purchases during the year:
- Beginning inventory (Jan. 1): 100 cases @ $5 each = $500.
- March purchase: 100 cases @ $7 each = $700.
- September purchase: 100 cases @ $9 each = $900.
You sell 200 cases during the year at $15 each = $3,000 revenue. At the end of the year, 100 cases remain unsold.
Under FIFO, you assume the oldest inventory sells first.
- Cost of 200 cases sold:
- 100 cases @ $5 = $500 (beginning inventory).
- 100 cases @ $7 = $700 (March purchase).
- COGS = $1,200.
- Ending inventory: 100 cases @ $9 = $900.
- Gross Profit = $3,000 – $1,200 = $1,800.
Under LIFO, you assume the newest inventory sells first.
- Cost of 200 cases sold:
- 100 cases @ $9 = $900 (September purchase).
- 100 cases @ $7 = $700 (March purchase).
- COGS = $1,600.
- Ending inventory: 100 cases @ $5 = $500.
- Gross Profit = $3,000 – $1,600 = $1,400.
Using the COGS equation, we can see that Beginning inventory ($500) + Purchases ($1,600) – Ending inventory = COGS.
- FIFO: $500 + $1,600 – $900 = $1,200.
- LIFO: $500 + $1,600 – $500 = $1,600.
This demonstrates that in an inflationary environment (rising prices), FIFO results in lower COGS ($1,200 vs $1,600) and higher gross profit ($1,800 vs $1,400).
These numbers don’t just impact your financial statements; they’re also used to calculate your business taxes. Though FIFO is more accurate, it does result in higher taxes due to its lower COGS and higher profits. This is why the IRS makes FIFO the default method when calculating inventory.
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