FIFO vs LIFO: The Differences Between Inventory Valuation Methods

If your business is product-oriented, you probably spend a lot of time talking about inventory. And for many businesses, inventory represents a large portion of their assets. Inventory is a critical part of your business’s balance sheet. So, what does this all mean? If you own a retail, manufacturing, or wholesale business, inventory management is crucial. We’ll talk about the differences between two standard methods for inventory valuation, FIFO vs LIFO, and how you can choose the best system for you. The system you choose can affect your business taxes, income, profitability, and more.

What is inventory?

Before diving into First-In-First-Out (FIFO) and Last-In-First-Out (LIFO) accounting, let’s breakdown inventory. Inventory is the company’s goods. It can be divided into three categories: raw materials, work-in-progress items, and finished inventory. When your business holds inventory, you must assign value to the products sold and the products that remain in the warehouse. Since it can be sold, inventory is classified as an asset. Businesses need to accurately value their assets in order for the entire business to be valued properly.

There are two important components to inventory: cost of goods sold (COGS) and ending inventory.

Ending inventory formula

The value of a business’ inventory is determined using the ending inventory formula, which is:

Beginning inventory + Net purchases – COGS = Ending inventory

You’ll need to use the ending inventory calculation in both FIFO and LIFO accounting methods. Note that each method will have different effects on COGS and ending inventory values. The difference will appear on both your balance sheet (inventory) and income statement (COGS).

Comparing and contrasting FIFO vs LIFO

FIFO vs LIFO accounting are different in one primary way: each method makes a different assumption about the units sold. FIFO and LIFO both exist to allow companies to record the movement of their inventory. The amount you pay for materials, labor, and overhead costs is continually changing and so the cost to make a product last week may be different than this week. FIFO and LIFO both determine which item is sold first, but they do this differently. The different results are also due to inflation. Prices of labor and materials steadily rise under an inflationary economy, so goods purchased earlier (generally under the FIFO method) are typically bought at lower costs than newer goods (generally under the LIFO method). Let’s walk through each inventory valuation method.

The First-In-First-Out (FIFO) method

FIFO, or first-in-first-out, assumes that a business sells its oldest inventory first. The first batch of inventory that is manufactured or purchased is also the first to be sold, which leads to steady inventory turnover. Businesses that sell perishable goods or products that change often (like a clothing company following trends, or a grocery store with items that expire) tend to use the FIFO method. Since the cost of labor and materials will always change, FIFO is helpful in ensuring that current inventory reflects the current market value. This method also assumes that older inventory is less expensive than current items. 

Using FIFO for inventory valuation

When you sell older inventory first, the financial results are different. Here’s how the components of inventory valuation will look if your business uses the FIFO method:

1. COGS: Your cost of goods sold will be lower when you sell older, cheaper inventory first.
2. Ending inventory: Your ending inventory balance will be higher since the newer, more expensive inventory is remaining.
3. Profit: Because your COGS will be lower, the FIFO method usually generates a higher net income, or profit.

Benefits:

1. Reflects Actual Flow of Goods: FIFO assumes the oldest inventory items are sold first, which often reflects the actual flow of goods, especially in industries where products have a shelf life.
2. Higher Profits During Inflation: In times of rising prices, FIFO results in lower cost of goods sold because the older, cheaper items are being used up first. This can lead to higher reported profits.
3. Realistic Inventory Valuation: Remaining inventory on the balance sheet is valued at more recent costs, which can be more realistic and reflective of current market conditions.
4. Simplicity: FIFO is generally simpler to implement and understand, making inventory records straightforward, especially for companies with continuous inventory systems.
5. Compliance: Many international accounting standards, including International Financial Reporting Standards (IFRS), prefer FIFO, making it suitable for companies operating globally.

The last-in, first-out (LIFO) method

LIFO, or last-in, first-out, assumes that a business sells its newest inventory first. Because this is the opposite of FIFO, older inventory can end up staying on the shelves much longer. With LIFO, remaining inventory may not accurately reflect the current market value, since it likely has changed since the early inventory was taken in. Reduced tax liability is often the reason a business chooses this method. Although your net income will be lower on your balance sheet, your taxable income will be lower and thus you’ll have a reduced tax burden.

Benefits:

1. Tax Advantages During Inflation: In times of rising prices, LIFO results in higher cost of goods sold because the most recent, expensive inventory items are considered sold first. This reduces taxable income and therefore tax liability.
2. Matching Current Costs with Revenues: LIFO matches more recent costs with current revenues, providing a better reflection of current profitability in an inflationary environment.
3. Minimizes Inventory Write-downs: In certain situations, LIFO can reduce the likelihood of write-downs to market value, since ending inventory consists of older, possibly less market-valued items.
4. Cash Flow Benefits: Due to lower taxable income in inflationary periods, LIFO can improve cash flow by reducing taxes payable.
5. Strategic Financial Management: It can be used strategically to manage earnings and financial ratios, especially in industries with volatile pricing.

Using LIFO for inventory valuation

Here’s how the components of inventory valuation will look if your business uses the LIFO method:

1. COGS: Your cost of goods sold will be higher when you sell more expensive, newer inventory first.
2. Ending inventory: Your ending inventory balance will be lower since the older, cheaper items are still remaining.
3. Profit: Because your COGS will be higher, LIFO generates a lower profit.

FIFO vs LIFO: Advantages and disadvantages to consider

As you can see, the inventory management method you choose for your business will have impacts on your net income, financial statements, and inventory operations. A common point that can be seen as both a disadvantage and advantage of both methods is the impact on reported income and profits. For example, with FIFO, a higher gross income looks good to investors, but it COULD result in a higher bill at tax time. Conversely, the LIFO method may make a business appear less profitable on paper, but the business could also have a lower tax liability.

To most people, FIFO also feels more straightforward. It’s an accepted method under the International Financial Reporting Standards (IFRS) and makes it easier for businesses to manage inventory management on their own. LIFO, on the other hand, is not regulatory compliant in all jurisdictions. A little background – LIFO is banned under the IFRS, but the U.S. still operates under the guidelines of generally accepted accounting principles (GAAP). So, companies based in the U.S. that use LIFO have to convert their statements to FIFO in the footnotes of their financial statements. This difference is called the “LIFO reserve.” This means that FIFO can be used by both U.S. and internationally based companies but LIFO cannot.

Lastly, although FIFO encourages regular inventory turnover, this method can be a problem for businesses with stagnant inventory. If inventory remains stagnant over a few years there can be a large discrepancy between the COGS and market value when sales pick back up.

Using FIFO and LIFO in your small business

While LIFO vs FIFO sounds complicated, they’re actually fairly simple to implement. If you want to focus on other parts of your business besides the intricacies of inventory accounting, a bookkeeper can help you keep track of the management system and make sure everything is being recorded correctly. If you’re unsure about which system to implement, a knowledgeable bookeeper may also be able to help you consider how each will impact your bottom line, considering your specific business needs.

The FIFO method is usually seen as well suited for businesses that operate in industries where a product’s price remains steady and the business tends to sell the oldest inventory first. LIFO is more often utilized in industries where prices fluctuate and newest inventory is sold first. Businesses that are also looking to decrease their tax liability also tend to use LIFO.

How Block Advisors can help with small business needs

Inventory valuation can be time consuming when you do it yourself. The differences between LIFO and FIFO can lead to thousands of dollars of tax savings each year. Your choice between systems should not be taken lightly. But Block Advisors can help.

Get back to doing what you love and let our experts lighten your load, in person or virtually, year-round—as always—backed up by the Block Advisors guarantees. Our taxes, bookkeeping, payroll, and incorporation services are designed with small business owners like you in mind.

Speak with a certified small business pro today!

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.