Inventories are the largest current asset of any business. Businesses are often confused about FIFO Vs LIFO. Ideally, there are two inventory valuation methods or accounting methods: LIFO (Last-in, first-out) and FIFO (First-in, first-out), or for this blog; FIFO vs LIFO.
These are the two most used inventory methods for record-keeping that are feasible by accounting standards.
Inventory accounting assigns values and revenue figures that help one to make good business decisions for the long term. It also helps to keep an eye on the accounting profit, and so does comparing FIFO vs LIFO. Therefore, it becomes necessary to create a record containing the acquisition price, capital gains, current costs, and operating expenses.
Valuating inventory equations is a process through which companies or businesses offer monetary inventory value for their commodities and generate accurate financial statements. It is important to maintain accurate accounting records. In this article, we’ve explained each inventory valuation method in detail with examples. Here’s how you can use these methods for accounting records.
What is LIFO?
The LIFO (Last-in, first-out) is a standard inventory method or accounting method 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. The LIFO method is like any store where the clerks stock the last item from the front and customers purchase items from the 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, which makes it difficult for inventory costing methods.
Therefore the commodities at the end of inventory layers become old and gradually lose their value. This brings significant loss to the company’s business as high-cost inventory keeps adding up in the inventory totals for several years. The oldest inventory will always be held back at the end of the list. These generally accepted accounting procedures used for accounting purposes help to keep an eye on the current market prices and manage help in managing the remaining balance sheet value. It also makes various warehouse operations easy.
Reasons for using the LIFO method
The only reason for using LIFO from FIFO vs LIFO method is when companies assume that inventory costing methods and the higher inventory cost themselves will increase over time providing a higher value, which means prices will inflate. This means higher earnings for the company. While implementing the LIFO system, the cost of inventories at the end of inventory face price increases, as compared to inventories, purchased earlier.
Due to the rising prices of already present inventory items, this becomes a little complex.
Increasing unit costs affect sales price. It makes fundamental analysis of higher-cost items difficult in the recent inventory turnover. Inventory purchases month units are added to the existing inventory. This makes it easy to calculate gross profit, average cost method, and product unit cost. It also reduces high-income tax expenses.
This causes higher-cost items to be sold gaining higher profit. As a result, the ending inventory balance is valued at previous costs whereas the most recent costs appear in the cost of goods sold. Larger ending inventory unit cost value causes complications in goods calculation, which affects the current financial health and net profit of the company.
Advantages Of Using the FIFO vs LIFO Method :
- During an inflation environment, the cost of goods is higher whereas the remaining inventory balance is lower in FIFO vs LIFO. Through LIFO, the main advantage lies in reporting lower profits and getting around financial analysis.
- It is more apt for cash accounting, inventory purchase, matching cost revenue figures, and allowing a complete recovery of material cost in FIFO vs LIFO. It helps to validate the published financials and the income statement.
- LIFO is simple to understand and easy to operate among these inventory management systems and hence proves to be better in the FIFO vs LIFO domain.
- By moving high-cost inventories to the cost of goods sold, businesses can lower their reported profit levels and defer income tax recognition for the total purchases using FIFO vs LIFO.
Disadvantages Of Using the FIFO vs LIFO Method :
- Firstly, in FIFO vs LIFO, inventory valuation does not talk about current prices or key financial statements hence LIFO is of no relevance, in assessing current situations and the total cost.
- It is more difficult and complex to maintain inventory cost accounting in the FIFO vs LIFO method. If most recently purchased inventories are always used as the cost of goods sold, it creates older and outdated inventories, which can never be sold. Therefore, it is quite unrealistic in rising price environments.
- LIFO calculations are more complicated, especially when current costs fluctuate. It might also cause a problem if there is an unusual increase in prices.
- Clerical work and inventory cost accounting areas are more important in the LIFO procedure. This might cause delays for financial accounting purposes.
- If businesses plan to expand globally, LIFO is not the right choice for valuing a company’s current assets or financial accounting.
Example of LIFO method
Using LIFO on the following information, in the scope of FIFO vs LIFO, to calculate the value of ending inventory and the total cost of goods sold for the accounting period 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:
LIFO Periodic
|
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 |
|
220 |
Rs.3440 |
||
|
Ending Inventory |
Units |
Unit Cost |
Total |
|
Inventory From Mar 27 Purchase |
50 |
Rs.15.00 |
Rs.750 |
LIFO Accounting in FIFO vs LIFO
|
Date |
Purchases |
Sales |
Balance |
||||||
|
Units |
Unit Cost |
Total |
Units |
Unit Cost |
Total |
Units |
Unit Cost |
Total |
|
|
Mar 1 |
60 |
Rs.15.00 |
Rs.900 |
||||||
|
5 |
140 |
Rs.15.50 |
Rs.2,170 |
60 |
Rs.15.00 |
Rs.900 |
|||
|
140 |
Rs.15.50 |
Rs.2,170 |
|||||||
|
14 |
140 |
Rs.15.50 |
Rs.2,170 |
10 |
Rs.15.00 |
Rs.150 |
|||
|
50 |
Rs.15.00 |
Rs.750 |
|||||||
|
27 |
70 |
Rs.16.00 |
Rs.1,190 |
10 |
Rs.15.00 |
Rs.150 |
|||
|
70 |
Rs.16.00 |
Rs.1,120 |
|||||||
|
29 |
30 |
Rs.16.00 |
Rs.480 |
10 |
Rs.15.00 |
Rs.150 |
|||
|
40 |
Rs.16.00 |
Rs.640 |
|||||||
|
31 |
10 |
Rs.15.00 |
Rs.150 |
||||||
|
40 |
Rs.16.00 |
Rs.640 |
|||||||
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 the accounting principles and the actual flow of goods, therefore it is considered the right way to value dynamic inventory. Also, it is a more logical approach, as the oldest goods get sold first, thereby reducing the risk of becoming obsolete.
In the FIFO process, goods that 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 of FIFO vs LIFO, 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 the cost of goods sold.
This gives the idea that gross margin doesn’t essentially reflect matching the cost and revenue numbers. During an inflationary environment, current-cost revenue is matched against older and low-cost inventory goods, which results in a maximum gross margin.
FIFO’s way of valuing inventory is accepted by international standards. It yields the same results for both periodic and perpetual inventory systems.
Advantages Of Using FIFO Vs LIFO Method :
- It is more realistic and practical, compared to LIFO. Also, it’s simple and easy in FIFO vs LIFO method.
- The FIFO vs LIFO theory is based on the logic of selling those inventories that are first purchased. Therefore, companies issue materials and utilize the goods that are set at higher prices 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 more recent purchases, therefore closing stock of materials is valued at market price.
- FIFO vs LIFO, when compared, FIFO is more useful when there aren’t many transactions and the prices are steady or have a relative value.
Example of FIFO method
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
1 January Purchased 5 bikes @ Rs.50 each
5 January Sold 2 bikes
10 January Sold 1 bike
15 January Purchased 5 bikes @ 70 each
25 January 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 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:
|
Date |
Purchase |
Issues |
Inventory |
||||||
|
Units |
Rs./Units |
Rs. Total |
Units |
Rs./Units |
Rs. Total |
Units |
Rs./Units |
Rs. Total |
|
|
Jan 1 |
5 |
50 |
250 |
5 |
50 |
250 |
|||
|
Jan 5 |
2 |
50 |
100 |
3 |
50 |
150 |
|||
|
Jan 10 |
1 |
50 |
50 |
2 |
50 |
100 |
|||
|
Jan 15 |
5 |
70 |
350 |
5 |
70 |
350 |
|||
|
Jan 15 |
7 |
450 |
|||||||
|
Jan 25 |
2 |
50 |
100 |
||||||
|
1 |
70 |
70 |
4 |
70 |
280 |
||||
Under the FIFO technique, the cost of inventory is related to the cost of the latest purchases, which is Rs.70.
Disadvantages Of Using FIFO Vs LIFO Method :
- The 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 a 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 benefits. FIFO inventory valuation results in higher amounts 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- FIFO Vs LIFO for your business?
If your business deals with supermarkets, drug stores, convenience stores, auto dealers, auto parts, heavy trucks and trailers, farm equipment, construction equipment, liquor beer, or wine stores; you can preferably opt for the LIFO method rather than FIFO in fifo vs lifo.
In sectors like building products and hardware, steel product selling, electrical supply, farm, and ranch supply stores; in dollar stores, sporting goods stores, apparel stores, electronic stores, furniture stores, and grocery and food products distribution, LIFO is the best way of valuing your current assets, making it look like the FIFO vs LIFO winner.
Income tax deferral is the most common answer for using LIFO while evaluating current assets. Due to this, this cash method of accounting is strictly banned according to standards of financial reporting. However, this accounting practice is prevalent across the US.
This method gets around paying higher taxes due to changing prices of inventories available for sale. This reduces the taxable income.
On the other hand, if you have a small business or you deal with perishable goods like fruits and vegetables, and goods for export this method is feasible because of its reverse order. Since all perishable products come with an expiration date, therefore the older ones bought are sold out first, to reduce the number of archaic inventories.
This ensures that the oldest product or the older items are sold out maintaining the physical flow or the product flow making place for the newest stock. Sectors like railways and banks also use the FIFO method. There are many accounting software available for the same.
Things become much easier if you use good accounting software. You can try ProfitBooks which helps businesses to manage the entire inventory cycle from purchase to sales.
