How you evaluate inventory can have major implications on your profitability. FIFO and LIFO are two common methods utilised for this task. But in some countries, only one inventory valuation strategy is permitted by law.
Join us as we break each inventory valuation method down and uncover the most important differences between FIFO vs LIFO.
What is FIFO?
First-in, first-out (FIFO) is a cost-flow inventory method used to value inventory stock. FIFO assumes the items first purchased or first produced are the first items to be sold. Under the FIFO method, the inventory you have left at the end of your accounting period would be the items you’ve most recently purchased or produced.
FIFO is an accurate and easy way to calculate your ending inventory value. It helps to ensure you are assigning the correct value for the cost of goods sold (COGS). By shipping your oldest inventory first, its price or value is represented as the most accurate estimate of each stock item or SKU.
When calculating your ending inventory value using FIFO, you’re reporting on the regular flow of inventory throughout your supply chain. This method is particularly beneficial in times of rising inflation because your more recent inventory would likely cost more than your older inventory stock.
You can save money managing your inventory using the FIFO method, which ensures more accurate financial reporting and is beneficial to your customers.
What is LIFO?
Last-in, first-out (LIFO) is a stock valuation method where the last items produced or placed into your inventory stock are the first items you sell. Under the LIFO method, the remaining inventory at the end of your accounting period is your older stock, the inventory that you purchased or produced first.
LIFO assumes that the cost of inventory increases over time, with the most recently acquired stock costing more than earlier purchases. Therefore, your ending inventory balance will be valued at the earlier, presumably cheaper cost, and your more recent costs reported as the cost of goods sold.
The LIFO method means that a company can lower its tax obligations by transferring high-cost inventory into the COGS and reporting a reduced net profit.
The LIFO cost flow method of inventory reporting is not permitted under the tax laws of many countries, such as the United Kingdom, Australia, and New Zealand. This is because LIFO potentially distorts or artificially lowers a company’s profitability and financial reporting.
FIFO vs LIFO – what’s the difference?
The difference between FIFO and LIFO is that the LIFO method sells or uses the oldest inventory first while the FIFO method sells or uses the newest inventory first.
To better understand how they differ, let’s look at some real-life examples.
The FIFO method
First-in, first-out takes the inventory purchased first, and sells these most recent purchases chronologically in the order of acquisition.
Imagine you’re a craft brewer.
From a production perspective, you sell the first batch brewed within the period before selling a subsequent batch. Sales at your cellar door would then use up your brewery stock with the oldest expiry date, followed by sales of inventory based on sequential expiry dates.
If you’re using a periodic inventory system, you should be checking inventory levels at fixed intervals on a weekly, monthly, or yearly basis. This ensures that the first batches you brew are the first batches you sell.
Using FIFO as an inventory accounting method means that your oldest inventory costs are assigned as the COGS. The cost of the more recently brewed remaining inventory is then recorded as ending inventory for the period.
The LIFO method
In contrast, LIFO keeps the inventory purchased first but sells the more recent purchases. Last-in is sold first.
A business that uses the LIFO method records its most recent inventory costs first. This method impacts financial reporting and obligations if the current economic conditions mean the cost of inventory is higher and if your sales are down.
Imagine you have a lighting business, and you purchase ten light fittings for $10 each.
The following week, you purchase a further 20 light fittings for $15 each.
In the preceding month, you sell a total of 15 light fittings at the price of $50 per fixture yet the price at which you purchased these items varies.
Using the LIFO method, you calculate the cost of the items at $15 per light fitting because this is the latest price of your inventory purchases. Your profit is $525 on the 15 light fittings you sold, meaning that although you bought the first 10 light fittings for $10 each, the light fittings sold will be calculated based on the last ones you bought at $15 each.
Conversely, under the FIFO method, your profit would be $200.
FIFO vs LIFO: Advantages and disadvantages
There is a time and place for the FIFO and LIFO methods. The disadvantages of FIFO will matter less for certain business types, while the disadvantages of LIFO will matter less for others.
The most important thing is that you select the most efficient method for your specific business type, size, and industry.
To determine which one that will be, let’s break down the pros and cons of each.
Advantages of FIFO
The FIFO method is a practical approach that identifies the costs of the products you sell, at the point of sale.
It can save you both time and money by calculating the exact cost of the inventory you’ve sold since your costs are reliant on the cash flows of your previous purchases.
Here are 4 key benefits of using the FIFO methodology:
1. Up-to-date inventory data
FIFO provides the most accurate analysis of what your inventory is costing your business at any given time.
Aligning your current business costs more accurately to the actual flow of inventory out of your business, FIFO provides better accounting and a more real-time assessment of where your business stands – particularly if your business deals in large volumes of inventory.
2. Works with modernised business systems
FIFO is software compatible, with most accounting software designed specifically for the FIFO method of accounting for inventory which is also easy to use and apply.
The FIFO method allows you to easily apply it through the management of inventory costs using and recording your most recent purchases or productions in the order they occur.
3. Accurate margins
FIFO shows your true gross and net profits in times of increasing inventory prices. It removes the ambiguity of financial reporting because the values used in your cost of sales figures are more accurately represented on your profit and loss statement.
4. Increases the value of your business to buyers
FIFO calculates a higher profit because the cost of goods is inclined to increase over time. This means that your business will be worth more to potential buyers or investors.
If you calculate the difference between what you currently sell a product for with the cost to your business of past inventory, you are liable to see increased profits in comparison to the inventory you are purchasing in real time.
Disadvantages of FIFO
The main disadvantage of using the FIFO valuation method is that it will result in higher profits during times of inflation. This means that you are then faced with more taxes because tax obligations are tied to your business profits.
Other disadvantages of using the FIFO methodology:
1. Unsuitable for volatile pricing
The FIFO method is not a suitable measure when you have inventory purchases or production with fluctuating prices. Inaccurately stated profits will often appear for the same period because you have different costs recorded for the same goods during that matching period.
2. More complex than LIFO
The FIFO pricing method of valuation is simple to understand but may get difficult to use when you’re attempting to extract your costs of goods. This is because a significant amount of data is required for this method which can result in accounting errors.
3. Many factors affect inventory valuation
FIFO, like any other inventory pricing or accounting method is based on contemporary rates of inflation.
As such, it may oversimplify your calculation of inventory costs. These costs can absorb the effects of variables, making your inventory valuation reliant on many different factors such as fluctuations in supply and demand or foreign exchange activities.
Advantages of LIFO
A key benefit of the LIFO method of accounting for inventory is that it helps to mitigate rising inventory costs. Profits under LIFO are more appealing to investors during periods of economic reductions in pricing.
3 additional benefits of using the LIFO methodology:
1. More accurate current earnings valuation
LIFO exaggerates the COGS and understates profit. It provides a better measurement of your business’s current earnings, reducing inventory profits by matching your most recent costs against your current revenues.
2. It offers tax benefits and improves your cash flow
When using the LIFO valuation method during times of inflation, your current higher-cost purchases are matched against revenues to ensure profits are not overstated. This reduces income tax costs and as a result, improves your business cash flow.
3. Can align with receiving process
In some instances, the LIFO method integrates perfectly with your physical flow of inventory. For example, when inbound pallets of inventory are stacked vertically as they are received, the last pallet (the one on the top) is always the first pallet of inventory to be used.
Disadvantages of LIFO
The main disadvantage of using the LIFO valuation method is that it is incompatible with International Financial Reporting Standards and not accepted under the tax laws of many countries. There is also the risk that older inventory items will get damaged or become obsolete.
Other disadvantages of using the LIFO methodology:
1. Misleading inventory data
Inventory is generally understated on your balance sheet when using the LIFO method because its valuation is based on the oldest costs. This means that your working capital position may appear worse than it is.
2. Higher taxes
LIFO may inflate your reported income for a given financial period which results in higher tax expenses for that period.
To avoid higher tax payments companies may purchase large quantities of inventory to match against their revenues. This can lead to businesses adopting poor buying habits under the LIFO method.
3. Largely impacted by inflation
During periods of inflation, LIFO reduces reported earnings. This has the potential to hurt investment and reduce the stock price of your company.
LIFO is difficult to understand with many investors unable to grasp its complexities and the impact of inflation on the business’s reported earnings.
FIFO vs LIFO: Which one should you use?
Businesses selling perishable goods, such as food and beverage manufacturers, and businesses based in countries where LIFO is not permitted should use the FIFO method.
FIFO reduces costs, improves efficiencies, and increases customer satisfaction. It also helps you to quickly identify any discrepancies in your inventory allowing you to make any necessary adjustments promptly and effortlessly.
The FIFO approach also ensures that raw materials are used correctly within your production processes, mitigating any risk of defects, delays, or expired inventory stock.
If your business operates in the automotive industry, you should use the LIFO method (if it’s permitted in your country) because LIFO consistently values ending inventory lower than any other valuation method.
LIFO matches inventory costs to revenue, and it can also improve your cash flow relative to taxes paid. It constantly brings you tax savings that can be reinvested back into your business.
Due to the consistent increase in vehicle costs the LIFO method can provide you with significant income tax benefits and deferment. LIFO also minimises write-downs of vehicles to fair market value or the price a vehicle would sell for in an open market, because of a decline in inventory costs.