FIFO vs LIFO Inventory Valuation

In some cases, we earn commissions when sales are made through our referrals. These financial relationships support our content but do not dictate our recommendations. Our editorial team independently evaluates products based on thousands of hours of research. On the other hand, manufacturers create products and financial performance definition must account for the material, labor, and overhead costs incurred to produce the units and store them in inventory for resale. LIFO is more difficult to account for because the newest units purchased are constantly changing.

FIFO accounting results

Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times. By offsetting sales income with their highest purchase prices, they produce less taxable income on paper. Choosing between FIFO and LIFO extends beyond accounting methods, aligning with your business’s goals, tax planning strategies, and financial reporting requirements.

Why Does FIFO Matter for Your Costs and Inventory?

First in, first out (FIFO) and last in, first out (LIFO) are two standard methods of valuing a business’s inventory. Your chosen system can profoundly affect your taxes, income, logistics and profitability. We collaborate with business-to-business vendors, connecting them with potential buyers.

Companies that undergo long periods of inactivity or accumulation of inventory will find themselves needing to pull historical records to determine the cost of goods sold. LIFO usually does not reflect inventory replacement costs as well as other inventory accounting methods. The LIFO method of inventory accounting is a more complex method of costing inventory. Under LIFO, the gasoline station would assign the $2.50-per-gallon gasoline to cost of goods sold, since the assumption is that the last gallon of gasoline purchased is sold first. The remaining $2.35-per-gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period. Under FIFO, the gasoline station would assign the $2.35-per-gallon gasoline to cost of goods sold, since the assumption is that the first gallon of gasoline purchased is sold first.

Even if a company produces only one product, that product will have different cost values depending upon when they produce it. When inventory is acquired and when it’s sold have different impacts on inventory value. Although a business’s real income and profits are the same, using FIFO or LIFO will result in different reported net income and profits.

How Are Unrealized Inventory Profits Created?

Companies dealing with high-value items with no specific expiration date, such as luxury goods, jewelry, or non-perishable collectibles, might opt for LIFO to better match costs with revenues. This method might help effectively manage cost flow, aligning it more closely with current market prices. However, it maintains consistency and transparency in your financial records, aligning closely with international financial reporting standards (IFRS), which only recognize FIFO. However, please note that if prices are decreasing, the opposite scenarios outlined above play out. In addition, many companies will state that they use the “lower of cost or market” when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO, or average cost.

In contrast, LIFO results in higher COGS and lower reported gross income. We’ll explore the differences between FIFO and LIFO inventory valuation methods and their relationship to inventory valuation, inflation, reporting, and taxes. We’ll also examine their advantages and disadvantages to help you find the best fit for your small business. Due to economic fluctuations and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered more profitable – at least on paper.

What Is the Impact of LIFO on Financial Statements?

In contrast, using the FIFO method, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200. On your income statement, FIFO tends to show a higher net income, especially during inflation, because the older, less expensive stock lowers COGS. Read on to uncover the specifics of FIFO and LIFO methods, exploring their impacts, benefits, and scenarios in which each method may best serve your business. This system is preferred by most companies, but it is especially used in companies where the inventory is perishable or subject to quick obsolescence. Outside the U.S., LIFO is prohibited under IFRS accounting rules followed in most countries.

Since prices tend to rise rather than fall over the long term, then using FIFO will generally produce a larger profit which in turn means a larger tax bill. 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. But as you sell through your inventory, you begin selling goods that were actually acquired for a higher price at some earlier time.

1. So FIFO aligns with the real inventory flow while LIFO follows an accounting construct that does not reflect operational reality.
2. To calculate the profit a company produces, it must track sales revenue as well as the costs involved in producing its products.
3. The method a business chooses to account for its inventory can directly impact its financial statements.
4. Using the higher inventory costs (first in) would lead to a lower reported net income or profit for the accounting period (versus last out).

The IFRS guidelines mandate the use of FIFO for inventory valuation for any entities adhering to these international standards. We’ll use an example to show how FIFO and LIFO produce different inventory valuations for the same business. LIFO, or Last In, First Out, assumes that a business sells its newest inventory first. This is the opposite of the FIFO method and can result in old inventory staying in a warehouse indefinitely. While FIFO and LIFO sound complicated, they’re very straightforward to implement. Accounting for inventory is essential—and proper inventory management helps you increase profits, leverage technology to work more productively, and to reduce the risk of error.

FIFO (first in, first out) assumes the first inventory purchased is also the first inventory sold. The earliest acquired inventory items are assumed to leave the company first. A company’s recordkeeping must track the total cost of inventory items, and the units bought and sold. FIFO and LIFO produce a different cost per unit sold, and the difference impacts both the balance sheet (inventory account) and the income statement (cost of goods sold). It facilitates simpler inventory management that can lead to more accurate inventory records. It also minimizes complications in warehouse management and inventory accounting, predicting inventory balance, and managing supply chain logistics.

LIFO usually doesn’t match the physical movement of inventory, as companies may be more likely to try to move older inventory first. However, companies like car dealerships or gas/oil companies may try to sell items marked with the highest cost to reduce their taxable income. The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory–or the oldest inventory–is the sold first.

By selling your newest, pricier inventory first, LIFO increases your cost of goods sold on paper, which can lower your taxable income. However, it also means your profit margins might look general ledger example slimmer when prices are up. Since you’re selling off your oldest inventory items first (often bought at lower prices), your reported cost of goods sold (COGS) stays relatively low.

FIFO vs. LIFO: Which Inventory Method Is Right for You

The Financial Accounting Standards Board (FASB) is the source for the GAAP standards. 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. A company would take the revenue total and subtract the inventory costs (as well as other expenses), to determine how much profit was earned.