Ever run out of something you needed to sell? It happens to the best of us! But keeping track of your stock is crucial for any business. Here's the thing: knowing how much you have isn't enough. You also need to know its value – how much it's worth to your business. This value can affect your profits!
This blog will explain how businesses figure out the value of their inventory. We'll focus on two common methods: FIFO (First-In, First-Out) and LIFO (Last-In, First-Out).
We'll break down the differences, show you how they work with clear examples, and then you can decide which one might be a better fit for your business. Let's get started!
Understanding Inventory Valuation Methods
Think about it this way: You buy t-shirts for your shop at ₹100 each, then sell them for ₹200. That extra ₹100 is your profit, right? But what if you buy more shirts at ₹120 each before selling the first ones? That changes the math a little.
This is where the cost of goods sold (COGS) comes in. It's the total cost of everything you sell – the t-shirts in this case. Why is this crucial? Because you need to subtract the COGS from your sales to get your actual profit. That makes sense, right?
Now, there are different ways to figure out the COGS, and that's where inventory valuation methods come in. These methods help us determine the value of the leftover stock (the t-shirts you haven't sold yet). There are two main methods we'll be focusing on:
-
FIFO (First-In, First-Out): Imagine those t-shirts you bought first are the first ones you sell – like a queue at the store!
-
LIFO (Last-In, First-Out): Think of it like the opposite – you sell the most recently bought t-shirts first.
LIFO vs. FIFO: A Closer Look
Imagine you're running a shop selling cool phone cases. You want to figure out the value of your leftover stock, but there are different ways to do this. Here's where FIFO and LIFO come in – they're like two different ways of organizing a line at your store!
-
FIFO (First-In, First-Out): This method assumes the phone cases you bought first are the ones you sell first. Think of it like a traditional queue – the customers who came in first get served first. In this case, the cost of the earlier phone cases (the ones you bought first) is used to calculate the COGS (cost of goods sold).
-
LIFO (Last-In, First-Out): This method flips things around. Here, you imagine selling the most recently bought phone cases first. So, the cost of the latest phone cases you purchased is used to calculate the COGS. It's like a special VIP line where the newest customers get served before the others!
Here's a table summarizing the key differences between FIFO and LIFO:
| Feature | FIFO (First-In, First-Out) | LIFO (Last-In, First-Out) |
|---|---|---|
| Selling Assumption | Sells older inventory first | Sells most recent inventory first |
| COGS Calculation | Uses cost of older inventory | Uses cost of most recent inventory |
| Impact on Profit (during Inflation) | May show lower profit | May show higher profit |
Let's break down the last point in the table: Impact on Profit (during Inflation). Imagine you buy phone cases at ₹100 each initially, but then the price goes up to ₹120. With FIFO, you're selling the cheaper cases first, so your COGS remains lower, potentially leading to a slightly lower profit figure. On the other hand, LIFO uses the cost of the more expensive (latest) phone cases, potentially showing a higher profit during inflation.
Remember: This is a simplified example, and the actual impact on profit can vary depending on your specific situation.
Also Read: A Guide to Managerial Accounting and the Ways It Can Streamline Your Business
Calculating Inventory Valuation with Examples – Let's See Them in Action!
Alright, now that we understand the core concepts of FIFO and LIFO, let's see how they work in practice with some easy-to-follow examples. We'll calculate the COGS (cost of goods sold) using each method.
Example 1: Calculating COGS with FIFO
Imagine you run a small stationery store. Here's what's happening with your blue notebooks:
- You bought 10 notebooks at ₹20 each (Total Cost: ₹200).
- You then bought 5 more notebooks at ₹25 each (Total Cost: ₹125).
- By the end of the month, you've sold 8 notebooks.
How do we find the COGS using FIFO (assuming you sold the older stock first)?
-
Cost of notebooks sold: Since you sold 8 notebooks, and you bought them at ₹20 each initially, the cost would be: 8 notebooks * ₹20/notebook = ₹160.
-
Therefore, your COGS using FIFO is ₹160.
Example 2: Calculating COGS with LIFO
Now, let's imagine the same scenario with blue notebooks, but this time we'll use LIFO (assuming you sold the most recent stock first).
- You bought 10 notebooks at ₹20 each (Total Cost: ₹200).
- You then bought 5 more notebooks at ₹25 each (Total Cost: ₹125).
- By the end of the month, you've sold 8 notebooks.
How do we find the COGS using LIFO (assuming you sold the newer stock first)?
-
Cost of notebooks sold: Since you sold 8 notebooks, we need to consider the cost of the most recent purchase (5 notebooks at ₹25 each). So, the cost would be: 8 notebooks * ₹25/notebook = ₹200.
-
Therefore, your COGS using LIFO is ₹200.
See the difference? With FIFO, the COGS is lower because we used the cost of the older, cheaper notebooks. With LIFO, the COGS is higher because we used the cost of the newer, more expensive notebooks.
Remember: These are simplified examples, and real-life calculations might involve more complex scenarios. But hopefully, this gives you a good grasp of how FIFO and LIFO work in determining the COGS.
Choosing the Right Method: FIFO vs. LIFO – Picking the Perfect Fit for Your Business
Now that you've seen FIFO and LIFO in action, you might be wondering: which method is better? Well, the truth is, there's no one-size-fits-all answer! What works best for your business will depend on a number of factors. Let's examine the benefits and drawbacks of each strategy:
-
Simpler to Implement: FIFO is generally easier to understand and manage. It follows a more intuitive flow, similar to how you might sell items in a store – the first ones get in, sold first.
-
Aligns with Physical Flow (Often): In many cases, FIFO reflects the actual physical movement of your inventory. You're likely selling the older stock that's been sitting on the shelves for a while.
Disadvantages of FIFO:
-
May Not Reflect Current Costs (During Inflation): Imagine buying phone cases at ₹100 each, then the price goes up to ₹120. With FIFO, you're selling the cheaper cases first. This might not reflect the true cost of replacing your inventory, especially during periods of inflation.
-
Potentially Higher Taxes: Since FIFO often shows a lower profit (due to using the cost of older inventory), you might end up paying slightly higher taxes.
Advantages of LIFO:
-
May Reflect Current Costs (During Inflation): Remember the phone case example? With LIFO, you're using the cost of the most recent (expensive) purchases to calculate COGS. This can be helpful during inflation because it shows a more accurate picture of the replacement cost of your inventory.
-
Potentially Lower Taxes: Since LIFO might show a higher profit (due to using the cost of newer inventory), you could potentially pay lower taxes.
Disadvantages of LIFO:
-
More Complex to Implement: LIFO requires more record-keeping and calculations compared to FIFO. It can be trickier to track the cost layers of your inventory.
-
May Not Align with Physical Flow: In some cases, LIFO might not reflect the actual flow of your inventory. You might be selling older items while newer ones sit on the shelves.
Here's a quick tip: Think about the type of products you sell and how prices are likely to change. If you deal with perishable items or experience frequent price fluctuations, LIFO might be a better option. For businesses with stable prices and simpler inventory management, FIFO could be the way to go.
Also Read: Inventory Management: The Backbone of a Smooth-Running Business
Is LIFO Allowed Under GAAP? – Understanding the Rules
Great question! Let's clear up the rules around LIFO. There are two main accounting principle standards to consider:
-
GAAP (Generally Accepted Accounting Principles): These are the accounting standards followed by businesses in the US. The good news for US companies is that LIFO is allowed under GAAP for inventory valuation.
-
IFRS (International Financial Reporting Standards): These are the accounting standards used in many countries outside the US. Unlike GAAP, IFRS does not recommend the use of LIFO.
Here's the key takeaway:
- US companies: You have the option to use LIFO under GAAP, but there are limitations (like consistent use and specific calculations).
- Companies operating outside the US: If you follow IFRS, LIFO is not recommended. You'd likely use FIFO for international operations.
In short, the legal allowance of LIFO depends on your location and the accounting principles you follow.
Choosing the Best Method
Looking at the points above, FIFO seems to have the upper hand – it's simpler and more widely accepted. So, unless LIFO makes perfect sense for your business and your country allows it, FIFO might be your best bet!
