Inventories are the largest current asset of any business. Inventory valuation is a process through which companies or businesses offer monetary value for their inventories and generate accurate financial statements. It is important to measure inventories for matching expenses and revenue figures and take good business decisions for a long-term.
Ideally, there are two ways of doing so: LIFO (Last-in, first-out) and FIFO (First-in, first-out). Businesses are often confused about FIFO Vs LIFO. In this article, we’ve explained each inventory valuation method in detail with examples.
What is LIFO?
The LIFO (Last-in, first-out) process is mainly used to place an accounting value on inventories. It is based on the theory that the last inventory item purchased is the first one to be sold. LIFO method is like any store where the clerks stock the last item from front and customers purchase items from front itself. This means that inventory located at the back is never bought and therefore remains in the store. Presently, LIFO is hardly practiced by businesses since inventories are rarely sold, therefore they become old and gradually lose their value. This brings significant loss to company’s business.
The only reason for using LIFO is when companies assume that inventory cost will increase over time, which means prices will inflate. While implementing LIFO system, cost of recently obtained inventories goes higher, as compared to inventories, purchased earlier. As a result, the ending inventory balance is valued at previous costs whereas the most recent costs appear in the cost of goods sold. By moving high-cost inventories to cost of goods sold, businesses can lower their reported profit levels and defer income tax recognition. Therefore, income tax deferral is the most common answer for using LIFO while evaluating current assets. Due to this, it is strictly banned according to standards of financial reporting; however prevalent across US.
Advantages Of Using LIFO Method :
- During inflation environment, cost of goods is higher whereas remaining inventory balance in lower. Through LIFO, the main advantage lies in reporting lower profits, which in turn, allows businesses to pay less tax.
- It is more apt for matching cost and revenue figures and allows complete recovery of material cost.
- LIFO is simple to understand, easy to operate.
Disadvantages Of Using LIFO Method :
- Firstly, inventory valuation does not talk about current prices, hence LIFO of no relevance, in assessing current situations.
- It is more difficult and complex to maintain. If most recent purchased inventories are always used as cost of goods sold, it creates older and outdated inventories, which can never be sold. Therefore, it is quite unrealistic.
- LIFO calculations are more complicated, especially when prices keep fluctuating.
- Clerical work is more in LIFO procedure
- If businesses plan to expand globally, LIFO is definitely not the right choice for valuing company’s current assets.
Example of LIFO method
Using LIFO on the following information to calculate the value of ending inventory and the cost of goods sold as of March.
|March 1||Beginning Inventory||60 units @ Rs. 900.00|
|March 5||Purchase||140 units @Rs. 930.00|
|March 14||Sale||190 units @ Rs.1140.00|
|March 27||Purchase||70 units @ Rs.960.00|
|March 29||Sale||30 units @ Rs.1170.00|
Here is a Solution:
|Units Available for Sale||= 60 + 140 + 70||= 270|
|Units Sold||= 190 + 30||= 220|
|Units in Ending Inventory||= 270 − 220||= 50|
|Cost of Goods Sold||Units||Unit Cost||Total|
|Sales From Mar 27 Inventory||70||Rs.960.00||Rs.67,200|
|Sales From Mar 5 Purchase||140||Rs.930.00||Rs.1,30,200|
|Sales From Mar 1 Purchase||10||Rs.900.00||Rs.9000.00|
|Ending Inventory||Units||Unit Cost||Total|
|Inventory From Mar 27 Purchase||50||Rs.15.00||Rs.750|
|Units||Unit Cost||Total||Units||Unit Cost||Total||Units||Unit Cost||Total|
What is FIFO?
FIFO (First-in, first-out) method is based on the perception that the first inventories purchased are the first ones to be sold. It is a cost flow assumption for most companies. Since the theory perfectly matches to the actual flow of goods, therefore it is considered as the right way to value inventory. Also, it is more logical approach, as oldest goods get sold first, thereby reducing the risk of getting obsolete.
In the FIFO process, goods which are purchased earlier are the first ones to get removed from the inventory account and the remaining goods are accounted for the recently incurred costs. As a result, the inventory asset recorded in the balance sheet has cost figures close to the most recent obtainable market values. By this method, older inventory costs are matched against current earnings and are recorded in cost of goods sold. This gives an idea that gross margin doesn’t essentially reflect on matching the cost and revenue numbers. During inflation, current-cost revenue is matched against older and low-cost inventory goods, which results in maximum gross margin. FIFO way of valuing inventory is accepted in international standards. It yields same results for both periodic and perpetual inventory system.
Advantages Of Using FIFO Method :
- It is more realistic and practical, compared to LIFO. Also, it’s simple and easy.
- The theory is based on the logic of selling those inventories which are first purchased. Therefore, companies issue materials and utilize the goods that are received first.
- During inflation, FIFO has the potential to enhance the value of remaining inventory and bring higher net income.
- Showing more assets and income helps businesses to fish in potential investors and lenders.
- Since closing stock comprises of more recent purchases, therefore closing stock of materials are valued at market price.
- FIFO is more useful when there aren’t many transactions and the prices are steady.
Example of FIFO method
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ Rs.50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be calculated as follows:
The sales made on January 5 and 10 were clearly made from purchases on 1st January. Of the sales made on January 25, it will be assumed that 2 bikes relate to purchases on January 1 whereas the remaining one bike has been issued from the purchases on 15th January. Therefore, the value of inventory under FIFO is as follows:
|Units||Rs./Units||Rs. Total||Units||Rs./Units||Rs. Total||Units||Rs./Units||Rs. Total|
Under FIFO technique, cost of inventory is related to the cost of latest purchases, that is Rs.70.
Disadvantages Of Using FIFOMethod :
- FIFO model fails to present an accurate depiction of costs when prices of materials increase rapidly. When prices double or triple and accountants still use costs, dating back to months or perhaps years; there will be lot of cost issues that finance managers will fail to understand.
- There is no tax advantage, like LIFO. Companies incur huge expenses as income tax, which reduces financial benefit. FIFO inventory valuation results in higher amount of taxes, which further lower down cash flow and potential growth opportunities of any business.
- If consignments are frequently received that too at fluctuating prices at the time of material purchase, there are higher chances of clerical errors. It becomes tough for the ledger clerks to ensure the accurate price to be charged.
Which is the best inventory valuation method for your business?
If your business deals with supermarkets, drug stores, convenience stores, auto dealers, auto parts, heavy trucks and trailers, farm equipment, construction equipments, and liquor beer or wine stores; you can preferably opt for LIFO method.
Also if you are in sectors like building products and hardware, steel product selling, electrical supply, farm and ranch supply stores, dollar stores, sporting goods store, apparel stores, electronic stores, furniture stores and grocery and food products distribution, LIFO is the best way of valuing your current assets.
On the other hand, if you have small business or your deal with perishable products like fruits and vegetables, and goods for export. Since all perishable products come with an expiry date, therefore the first ones bought are sold out first, to reduce the number of archaic inventories. Sectors like railway and banks also use FIFO method.
Things become much easier if you use a good inventory management software. You can try ProfitBooks which helps businesses to manage entire inventory cycle from purchase to sales.See How ProfitBooks Can Help