LIFO Versus FIFO and How Each Method Values Inventory
As the name implies, First-In, First-Out (FIFO) is a way for companies to value their inventory. The first items put into inventory or produced by the company are accordingly the first taken out of inventory or transferred to customers and therefore expensed. When it comes to accounting for acquisition and/or production costs, initial and earlier costs are the first to be expensed, with more recent costs staying on the balance sheet to be expensed later.
Assume a company already has 200 widgets costing $4/widget. From there, the company increased its inventory at three more times during a selected accounting period. Three hypothetical, additional purchases include:
200 widgets @ $6/widget
200 widgets @ $7/widget
200 widgets @ $8/widget
If the company had 500 widgets purchased, there would be different considerations be it FIFO or LIFO. First, we’ll discuss FIFO.
For the 500 widgets sold to customers, the FIFO’s Cost of Goods Sold (COGS) (assuming there are no additional inputs that would increase the COGS for simplicity sake) would be $2,700.
This calculation will look at how COGS works for FIFO:
200 initial widgets costing $4/widget = $800 in COGS
200 widgets from the first additional purchase, costing $6/widget = $1,200 in COGS
100 widgets from the second additional purchase, costing $7/widget = $700 in COGS
For a total of $2,700 in COGS
Assuming there were no purchases during the selected accounting period, there would be 300 widgets remaining in inventory, or $3,000 in inventory costs. The inventory would show up on the balance sheet, according to the following calculation:
200 widgets @ $7/widget = $1,400 in inventory
200 widgets @ $8/widget = $1,600 in inventory
Now this is compared to LIFO, or Last-In, First-Out, which accounts for expenses by looking at most recent costs first. With the same company selling the same 500 widgets in the same accounting time-frame, but expensing their most recent 500 widgets first, here is the rundown:
200 widgets @ $8/widget = $1,600 in COGS
200 widgets @ $7/widget = $1,400 in COGS
100 widgets @ $6/widget = $600 in COGS
For a total of $3,600 expensed
The inventory would be left as the following:
100 widgets @ $6/widget = $600
200 widgets @ $4/widget = $800
For a total of $1,400 in remaining inventory.
Considerations Between LIFO and FIFO
One important consideration when choosing between LIFO or FIFO is that more likely than not input costs rise over time. Therefore, valuations can change based on the type of method.
Looking at the LIFO method, taking out inventory that’s been produced most recently does not always reflect market prices of the remaining inventory, especially if remaining stock is a few years old. Along with Costs of Goods Sold lowering net income, if older inventory is obsolete and it can’t be sold, it’ll render the inventory’s value far below market prices.
When it comes to the FIFO method, you get a better indication of the remaining inventory’s value. However, using this method increases a business’ net income since remaining inventory can be older and is valued by the Cost of Goods Sold. Similarly, if net income increases, there’s also a good chance of greater tax obligations for the company.
These scenarios account for rising prices. However, if prices are falling, then these scenarios would be reversed.
Thomas Jones is the lead tax partner at McConnell & Jones. With more than 40 years of experience in tax and accounting services, Mr. Jones is responsible for providing a complete range of financial services that promote long-term business success to entrepreneurs and small business owners such as tax planning and small business structuring.