FIFO vs. LIFO: Inventory Valuation (Differences, Examples, Alternatives, and How to Calculate)

What is Meaning FIFO vs. LIFO?

FIFO or the first in first out in inventory accounting is a method in which it is assumed that the oldest items of the inventory are the first to be sold out or used. On the other hand, LIFO, which stands for Last-In, First-Out, believes that the latest inventory items about the accounting period are the initial ones that are sold or used. The above methods are critical in controlling and assessing stock and management for accounting and taxation processes.

The decision of whether to use FIFO or LIFO depends on the business environment in which the company conducts its operations, the type of business that the company is in and its financial goals. The options available for these methods affect the balance sheets and mainly the recorded COGS and inventory at the end of the period. The method a business adopts dictates the value of inventory as reported on the balance sheet and the revenues and expenses on the income statement. Thus, FIFO is used under circumstances where the age of inventory is vital to the firm such as in the case of perishable goods such as foods or drugs while LIFO may be used under conditions where inventory costs are either fixed or tend to rise over time.

Impact of FIFO vs. LIFO

Financial Reporting

FIFO and LIFO are commonly used in reporting, and they have a considerable effect on Inventory and costs upon financial statement preparation. FIFO cleaves the inventory into groups where the first and oldest inventory costs are charged against the current revenues, thus lowering the COGS and raising the actual inventory value, especially during periods of inflation. It commonly increases the value of the reported net income since the percentage of COGS decreases due to the use of the older, and therefore, cheaper inventory. On the other hand, the LIFO method assigns the newest, and possibly higher, inventory costs to the current revenues, thus, resulting in higher COGS and lower inventory valuation. This may reduce the reported net income, and provide a ‘backup’ of earnings, which is useful when managing earnings and minimizing taxation.

During Inflation

The most significant decision on the application of the two methods is made during inflation. FIFO results in under-invoicing of the COGS and over-reporting the net income because the business uses the oldest cost of inventories in the valuation of current revenues. This makes a company appear more profitable but then has to pay more taxes following the accumulated income. On the same note, LIFO is advantageous because it offers a better matching of costs and revenues; it employs the up-to-date, high costs of inventories. This results in a higher calculation of COGS and reduced reported profits that are beneficial to organizations that want to mitigate the effects of inflation on the financial statements. Since it factors higher costs in COGS, LIFO alleviates the taxable income and offers a better perspective on a business entity’s profit in conditions of rising inflation.

Taxes

One of the essential areas affected by the voice of valuation methods of inventory is the tax effect relating to FOFO and LIFO. Concerning FIFO, lower COGS translate to high taxable income, and hence a company ends up paying more tax particularly where prices are on the rise. This can be a disadvantage to the business entities since they can be called upon to pay more taxes to cater to the wrongdoing. LIFO, however, raises the COGS and lowers the taxable income, which is very favorable in cutting short the taxes that a firm pays. Nevertheless, IFRS has prohibited the use of LIFO and thus firms that will operate in this new environment. This double tax reporting requirement is a plus since it enhances control when it comes to overall taxes.

Similarities and Differences

Similarities

• Purpose: FIFO and LIFO are two inventory costing methods applied in accounting to find the COGS and the balances of inventory on the financial statements.
• Impact on Financial Statements: While both methods impact key financial ratios like the gross profit on sales and net income on sales, they also alter the inventory figure on the balance sheet.
• Accounting Practices: Both FIFO and LIFO methods are legal methods outlined by the GAAP accounting practices that organizations in the United States Use.
• Tax Implications: Tax burden is affected because valuing for some companies results in a difference in the reported COGS and inventory, hence, taxable income.

Differences between FIFO and LIFO

Below is the difference between both methods:

Basis	FIFO	LIFO
Inventory Flow Assumptions	Oldest inventory items are sold first	Recent inventory items are sold first
Impact on Cash Flow	Less advantageous as it increases the tax liability	More advantageous as it decreases tax liability
International Reporting	Permitted by both GAAP and IFRS	Permitted only under GAAP
Impact on COGS	Lowers the amount of COGS	Higher the amount of COGS

How to Calculate FIFO and LIFO?

FIFO Method

FIFO (First-In, First-Out) is one of the accounting methods used in calculating the cost of goods sold.

The different processes followed in developing this method include the following:

• Step 1: It is recommended that the boxes carrying the inventory materials be ordered in chronological order from the oldest.
• Step 2: Total no. of Units = Units sold in the beginning + New number of units acquired – number of units returned.
• Step 3: Subtract the quantity sold with the first batch initially to the next batch if the required quantity is not available in the first batch.
• Step 4: Add the quantity sold for each batch to the price per unit and many of these to arrive at the total value for the cost of goods sold or the cost of sales.
• Step 5: Finally, to complete the inventory, take the quantities of the unsold stocks and multiply them with their purchase costs to arrive at their value.

LIFO Method

The LIFO formula is used when goods produced are sorted according to the order of production and the product with the final timestamp is considered the first to be sold.

The different processes followed in developing this method include the following:

• Step 1: Categories the inventory of purchases starting with the oldest thus simplifying the process of matching those with invoices.
• Step 2: To calculate it, you have to first know the total number of units of the product that was sold over the period in question.
• Step 3: Starting with the latest, mathematically determine the quantity you sold and see if it matches the batch, if not repeat the process with the next batch of the same product.
• Step 4: To arrive at the end total, take the total quantity sold from each batch and multiply it by the cost for that unit, to give the cost of goods sold (COGS).
• Step 5: To conclude the inventory, you ought to multiply the remaining unsold units by their purchase cost to arrive at their value.

Solved Example

Solving a problem based on inventory valuation will help us understand the difference between the two.

A company has the following inventory purchases during a month:

100 units purchased at $100 each

200 units purchased at $110 each

150 units purchased at $115 each

The company sells 250 units during the month.

FIFO Method Calculations

First 100 Units from:

100 units x $100 = $10,000

Next 150 Units:

150 units x $110 = $16,500

Therefore, Total COGS:

COGS = 10,000 + 16,500 = $ 26,500

Ending Inventory = (50 x $110) + (150 x $115) = $ 22,750

LIFO Method Calculations

First 150 Units from:

150 units x $ 115 = $ 17,250

Next 100 Units:

100 units x $ 110 = $ 11,000

Therefore, Total COGS:

COGS = 17,250 + 11000 = $ 28,250

Ending Inventory = (100 x $110) + (100 x $100) = $ 21,000

Pros and Cons

FIFO Method

Pros:

• Accurate Inventory Valuation: FIFO is suitable for valuing inventory on the balance sheet as the most recently acquired remainder.
• Enhanced Profitability: When a business has inflated its inventories, using FIFO leads to lower COGS and higher reported profit, which makes it useful in attracting investors and acquiring loans.
• Alignment with Physical Flow: FIFO is a good match with the way materials are arranged in business especially when they are inclined to spoil or become outdated.

Cons:

• Higher Taxes: FIFO produces an opportunity for higher taxable income during inflationary conditions as it offers a lower COGS, therefore creating a higher amount of profit.
• Potentially Misleading Profitability: Higher profits under FIFO during inflation generally are not the reflection of the existing cash flow position and cost pressures.
• Complexity in Record-Keeping: FIFO has the disadvantage of involving costly record-keeping of inventory costs and quantities thus causing more paperwork.

LIFO Method

Pros:

• Tax Benefits: LIFO can reduce the level of taxable income in conditions of inflation since, increasing COGS, reduces the tax burden.
• Matching Costs with Revenues: That is why LIFO offers what can be considered a better matching of costs and revenues for the most recent periods, offering what can be seen as a truer picture of profitability.
• Improved Cash Flow: trends of lower net income as a result of higher COGS under LIFO are positive for cash flow because of reduced tax burdens.

Cons:

• Outdated Inventory Valuation: LIFO can lead to prejudice on the balance sheet since the remaining inventory is stated at the older cost stating that it costs less than it does.
• Lower Profits: Due to the following, using LIFO in periods of inflation reduces profits which affects ratios and the view investors have about the company:
• Not Accepted Internationally: LIFO is not allowed in IFRS and therefore the method cannot be used for companies carrying out their business across borders or those preparing consolidated books of account.

Which Method is Better?

FIFO and LIFO both do not have a universal eligibility criterion and are subject to the economic conditions, prevailing standards of the industry, and growth planning factors. This procedure is useful in inflationary situations because it decreases the COGS and increases the profit levels, which can be useful when approaching investors and attempting to secure a loan.

Moreover, FIFO provides a better match with the flow of inventory and that is why it is applied in industries that deal with perishable goods for example food industries, drugs, and other similar industries. However, the use of FIFO leads to high taxable income and taxes during the inflationary time which might not be healthy for the companies to maximize taxes.

Nevertheless, LIFO can be advantageous in conditions of a rising price level because it brings about a rise in the COGS and a decrease in the taxable income, hence, the enhancement of cash flow. It aligns costs with the revenue at present, which can be potentially more accurate in terms of identifying profit under certain circumstances.

More Specifically, the LIFO method tends to put inventory in the balance sheet at older costs and thus may not represent the true cost of inventory. Also, LIFO is not recognized under IFRS, which makes the application of this method challenging for companies that operate internationally. Finally, it is up to the company to determine which method of accounting as the FIFO or LIFO to adopt or to amalgamate depending on their financial needs, best practices in the business domains, and relevant legislation.

Alternative Solution

Addressing the subject of inventory valuation, there is the method of the Weighted Average Cost in addition to FIFO and LIFO. The Weighted Average Cost method calculates the COGS and the ending inventory by averaging the cost of all units that are available for sale at whatever period being considered. The following method provides a clear average cost for every unit of stock; the total cost of the inventories is determined, and then divided by the quantity of inventories.

For instance, a business may buy and use 100 units at $10 each and 200 units at $12 each, the WAC will be obtained as follows; (100 units x $10 + 200 x $12) / 300 = $11. The COGS is then calculated by dividing this average cost per unit by the total number of units of the product sold, while the ending inventory is carried as the number of units still available at this average cost.

Compared to FIFO and LIFO, the Weighted Average Cost method gives relatively stable pieces of evidence of inventory and COGS over the accounting period by averaging the price changes. It is most applicable to organizations that use a huge quantity of the same goods; the idea of identifying particular costs of the inventory is inconvenient in this case. However, it does not necessarily capture the current cost of assets or the prices ruling in the current marketplace, particularly in cases of high inflation.

Conclusion

FIFO and LIFO have their advantages and disadvantages. FIFO is useful to give the current value of inventories and is most suitable for products that have a short shelf life, but it leads to a higher amount of tax in inflationary circumstances. LIFO provides an advantage in the taxation policies as the company can correlate the contemporary value of the inventory with the latest expenses incurred by the firm, but provides the disadvantage of inaccurate valuation that is not in compliance with IFRS. The suitability of the method depends on a company’s financial objectives, existing industry demands, and legal compliance.