FIFO and LIFO: Which Works Better for Inventory?

Post on Tuesday, May 29th, 2018 in Accounting

FIFO and LIFO are two methods of inventory valuation.

Inventory valuation helps to determine the Cost of Goods Sold (COGS) that includes the price (amount that you receive from selling your products) and cost (inventory-related expenses). In this article, we are going to compare FIFO vs LIFO, explain the difference between them, and highlight their pros and cons.

What Is FIFO & What Is LIFO?

FIFO – According to FIFO, or First in, First out, the oldest inventory items are sold first. As a result, the oldest cost of an item in inventory is removed. Then this cost appears on the income statement as part of the cost of goods sold. For example, a clothes store purchased 200 pairs of jeans at a cost of $ 10 per pair. Then the store purchased one more batch at a cost of $ 11 per pair. As a result, the COGS of $10 per pair ($10 x 200 = $ 2,000) is recorded on the income statement because that was the cost of the first items in the inventory. The $11 pairs of jeans will be allocated to ending inventory, and this figure will appear on the balance sheet.

LIFO – According to LIFO, or Last in, First out, the most current prices are reported in ending inventory. If we return to our previous example, $11 will appear on the income statement as COGS ($11 x 200 = $ 2,200). As you can see, the LIFO method overvalues the inventory and thus reduces income tax liability. 

Depending on the type of business you operate, you should choose the costing method that is most convenient for you – FIFO, LIFO, or weighted average. If your company sells the items that are not identical to each other, such as electronics or books, then you should choose either FIFO or LIFO. Let’s take a look at advantages and disadvantages of both methods.

Advantages of FIFO

  • Accurate reports – With FIFO, your balance sheet will show the exact prices you paid to purchase the inventory.
  • Simplicity – FIFO records the transactions in the same order as the items are purchased or produced, making the figures much easier to understand and process.
  • No depreciation – If you sell older items first, it will help you avoid depreciation of  their value. The FIFO method is perfect for companies with high inventory turnover.
  • Increased inventory value and net income – During inflation, FIFO increases the value of your inventory, because the inventory that you’re buying next is more expensive. It also increases your net income, because your older items with lower COGS would now be a smaller percentage of your sales price.
  • Suitable for international sales – The FIFO method is compliant with International Financial Reporting Standards, because it does not reduce the tax figures like LIFO, so you can use it if your business operates internationally.

Disadvantages of FIFO

  • Higher income tax liability – Lower COGS figures result in inflated profits. This can lead to a higher income tax expense, reducing the cash flow of your organization and potentially weakening the financial position of the business for the next accounting period.
  • Not good in case of fluctuating prices – If your business places many orders for products that have fluctuating prices, it can become difficult to manage the inventory and respective prices of each new shipment.
  • Failure to comply with the matching principle – According to the matching principle, companies should match and record revenue and costs within the same period. However, if a product has a slow turnover and its price may change during this delay, the revenues and costs are recorded in different periods, thus failing to comply with the matching principle.

Advantages of LIFO

  • Lower income tax liability – Many US businesses use the LIFO method when they have inventory with costs that change frequently. It helps them match the latest costs of products with the sales revenue of the current period, and thus reduce tax liability.
  • Fewer dividends – With lower reported profits, the business will have to pay fewer dividends and thus keep a better liquidity position without any pressure from shareholders.
  • Minimized markdowns of inventory – If your company uses LIFO, its net income is less likely to be affected by declining prices in the future. As a rule, businesses that use LIFO do not have a lot inventory at current higher prices because the most recent inventory, which is purchased at a higher price, is sold first. As a result, the chances of future markdowns of inventory are reduced.
  • Compliance with the matching principle – Unlike FIFO, LIFO complies with the matching principle, because the revenues and costs are recorded in the same period. As a result, both revenue and costs are recorded with the most recent values.

Disadvantages of LIFO

  • Non-compliance with the IFRS (International Financial Reporting Standards) – The LIFO valuation method will not allow your business to operate internationally because it is banned by the IFRS due to reduced income tax figures.
  • Difficult reporting – If you have high inventory turnover, with prices that rise and fall over time, then your stock valuation will not reflect the prices that you actually paid. As a result, your procurement and merchandising teams will never know exactly how much money you have held up in inventory.
  • Non-correspondence with normal physical flow of inventory – All produced or purchased items are typically used first, like in FIFO, but LIFO takes the opposite approach that may not suit specific industries, such as those who work with perishable goods.
  • Reduced profits – Although reduced profits in the income statements can help reduce taxes, they can be a drawback in cases when, for example. the company is looking for investors. Low figures in the income statements can present the company as a low performer and thus less attractive for potential investors.
  • Profits depend on accounting periods – Due to inflation, most inventory is procured at the beginning of accounting periods. As a result, the procurement activities should be shifted towards the end of the period for better profits. But such an approach will not suit all businesses, like those that sell seasonal goods.

LIFO vs FIFO: Which do you prefer?

Now you know how to do FIFO and LIFO as well as their benefits and drawbacks for your inventory management system. Please note that you should be very careful when choosing between the LIFO and FIFO methods for your business. After you have chosen the preferred method, it’s difficult to change it up down the road. 

All that being said, we want to know which method you prefer. Feel free to use the comments section on this page as a forum for discussion.

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