What Is LIFO vs FIFO? Understanding Key Inventory Valuation Methods

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. If there are any key takeaways from this, is the fact that the LIFO and FIFO inventory valuation method does not mean that LIFO and FIFO are used to track the physical flow of the goods in storage. At face value, no company or entity is able to predict the future cost of raw material. Hence the perceived notion that FIFO is a better accounting inventory practice seems far-fetched.

FIFO vs. LIFO: Comparing Inventory Valuation Methods

It presents a more accurate picture of the actual cost of goods sold, helping businesses manage profits and taxes more effectively. When a company follows the LIFO method, the ending inventory is valued at old prices. Consequently, the financial statements could present a distorted picture of the value of a company’s inventory. In the oil and gas industry, LIFO helps match the cost of sold oil with current market prices, providing a more accurate financial picture. Since the cost of labor and materials is always changing, FIFO is an effective method for ensuring current inventory reflects market value.

Why Is LIFO Accounting Banned in Most of the World?

To set an example, imagine you own a company that manufactures disposable coffee cups. For the sake of simplicity, you purchase plastic two times a year, once during the beginning months and once during the last months. During the first half of the year, you produce 1000 cups spending 1 dollar per cup. In the second half, you produce another 1000 cups, but the price of plastic has gone up so each cup costs you 2 dollars to make. At year-end, you create your financial statements and you find that you have brought in 4000 dollars in sales for selling 1000 cups at 4 dollars per cup.

LIFO and FIFO: Advantages and Disadvantages

All of our content is based on objective analysis, and the opinions are our own. LIFO is best suited for situations in which inventory needs to remain up-to-date and turnover is high, such as in retail stores or warehouses. It is not recommended for situations where stock needs to remain consistent or bulk discounts are available.

What’s the difference between FIFO and LIFO?

FIFO is generally a good pick in most cases, while LIFO can be advantageous in certain conditions, like steep cost increases or non-perishable inventory. Understanding these methods helps in making informed decisions for effective financial management. LIFO is more difficult to maintain than FIFO because it can result in older inventory never being shipped or sold.

One of the most significant advantages of LIFO is its ability to reduce taxable net income. By reporting higher costs of goods sold, LIFO lowers your profits, which, in turn, reduces your tax obligations. This can result in substantial tax savings, improving cash flow and offering more financial flexibility. This method can be advantageous in inflationary times because it aligns current revenue with current costs.

As a result, the company would record lower profits or net income for the period.
However, in deflationary periods, LIFO can lead to higher reported profits as lower recent costs are matched against revenues.
While LIFO is an accounting method, it can inform physical inventory management practices by highlighting the importance of managing newer, higher-cost inventory.
When inventory is acquired and when it’s sold have different impacts on inventory value.
There are several key aspects that has to be in place in order to have a warehouse ready for FIFO inventory flow.

It is up to the company to decide, though there are parameters based on the accounting method the company uses. In addition, companies often try to match the physical movement of inventory to the inventory method they use. While LIFO is primarily an accounting concept, it has implications for inventory management practices. Implementing LIFO often requires sophisticated inventory tracking systems that can maintain detailed records of costs and purchase dates. LIFO requires careful management of inventory layers, which can influence decisions about when to purchase new inventory. Although LIFO doesn’t necessarily reflect the physical flow of goods, it can inform decisions about which inventory to sell or use first.

The LIFO method hinges on the assumption that the most recently purchased or produced items (the “last-in”) are the first ones sold (the “first-out”) when calculating the cost of goods sold (COGS). In simpler terms, LIFO considers the ending inventory to consist of the older inventory items acquired at historically lower costs. This approach can significantly impact a company’s financial statements, particularly the balance electronic filing pin request sheet valuation of inventory and the reported COGS on the income statement. During inflationary periods, LIFO typically results in a higher Cost of Goods Sold (COGS) as more recent, higher-cost inventory is expensed first. The higher COGS leads to lower gross profit and net income compared to other inventory valuation methods. Lower reported income often results in lower tax liabilities, which is a key advantage of LIFO.

For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products. In other words, the seafood company would never leave their oldest inventory sitting idle since the food could spoil, leading to losses. Calculating the cost of goods sold using the LIFO method involves matching the cost of the most recent inventory purchases against revenue. Although there are several benefits to using the LIFO accounting method, there are also disadvantages that are important to note.

In industries with significant price volatility, LIFO can be part of a risk management strategy to mitigate the impact of price fluctuations on reported earnings. Companies using LIFO may need to consider the implications of their inventory valuation method in M&A scenarios. The prohibition of LIFO in many jurisdictions outside the United States is rooted in several factors. Critics argue that LIFO can lead to an unrealistic representation of a company’s assets, particularly during periods of inflation. There are also concerns that LIFO can be used to manipulate reported earnings through strategic inventory purchases. LIFO often doesn’t reflect the actual physical flow of inventory in most businesses, which goes against the principle of faithful representation in accounting.

And companies are required by law to state which accounting method they used in their published financials. The company made inventory purchases each month for Q1 for a total of 3,000 units. However, the company already had 1,000 units of older inventory that was purchased at $8 each for an $8,000 valuation. In the tables below, we use the inventory of a fictitious beverage producer called ABC Bottling Company to see how the valuation methods can affect the outcome of a company’s financial analysis.