FIFO vs. LIFO: Picking the Right Inventory Valuation Method for Your Business

Inventory valuation is important in determining your business’s financial health and tax obligations.

Choosing the right method—FIFO (First-In, First-Out) or LIFO (Last-In, First-Out)—can impact your profitability, cost of goods sold (COGS), and overall financial strategy. But how do you decide which method is best for your business?

In this guide, we’ll break down FIFO and LIFO, their advantages and disadvantages, and help you determine which inventory valuation method aligns with your business needs.

Understanding Inventory Valuation Methods

Let’s break it down with a simple example:

You buy t-shirts for your shop at ₹100 each and sell them for ₹200. Your profit for each t-shirt is ₹100, right? But what if you buy more t-shirts at ₹120 each before selling the first batch? Now, the profit calculation changes a little.

Here’s where Cost of Goods Sold (COGS) comes into play. COGS is the total cost of the items you sell – in this case, the t-shirts. Why does it matter? Because you need to subtract the COGS from your sales to figure out your actual profit.

Now, how do you figure out the COGS? This is where inventory valuation methods come in. These methods help you determine the value of the stock you still have left after selling some of it (the unsold t-shirts). The two most common methods are:

1. FIFO (First-In, First-Out): With FIFO, the first t-shirts you buy are the first ones you sell. It’s like a line at a store – the first customers in line get served first. This means the older stock is sold first, and the value of your remaining stock is based on the more recent purchases.

2. LIFO (Last-In, First-Out): In LIFO, you sell the newest t-shirts first. So, the most recently purchased items are sold first, and the older items stay in your inventory. This method can affect the value of your remaining stock and profits differently, especially in times of price changes.

These methods are important because they impact how much tax you pay, how you report profits, and how you manage your inventory.

Depending on the method you choose, your reported profit could be higher or lower, especially if the price of your t-shirts changes over time.

Both methods help you track your inventory more accurately, ensuring you report the right profit and manage your resources efficiently.

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.

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)?

1. 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.
2. 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)?

1. 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.
2. 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 know about FIFO and LIFO, you might be asking: which method should you choose? Well, the answer isn’t one-size-fits-all! What works best for your business depends on various factors. Let’s break down the benefits and challenges of each method:

FIFO (First-In, First-Out)

Advantages of FIFO:

1. Easier to Implement: FIFO is simple to understand and use. It's like selling the oldest items first in your store, which is a natural and intuitive way of handling stock.
2. Aligns with Physical Flow (Often): In many businesses, FIFO matches how products actually move. You're usually selling older stock that’s been on the shelves longer.

Disadvantages of FIFO:

1. May Not Reflect Current Costs (During Inflation): Let’s say you bought phone cases for ₹100, but the price goes up to ₹120. FIFO would make you sell the cheaper, ₹100 cases first, which could make your profits look lower than they are. This is a concern when prices are rising (inflation).
2. Potentially Higher Taxes: Since FIFO might show lower profits (due to using older, cheaper inventory), you might end up paying higher taxes.

LIFO (Last-In, First-Out)

Advantages of LIFO:

1. Reflects Current Costs (During Inflation): Using the example of phone cases again, with LIFO, you'd sell the newer, ₹120 cases first. This means your cost of goods sold (COGS) would reflect the more expensive current inventory, which is more accurate during inflation.
2. Potentially Lower Taxes: Since LIFO may show higher costs (due to using newer inventory), your profits might appear lower, which could mean you pay less in taxes.

Disadvantages of LIFO:

1. More Complex to Implement: LIFO is trickier to manage. You’ll need more detailed record-keeping to track the cost layers of your inventory.
2. May Not Align with Physical Flow: Sometimes, LIFO doesn’t match how inventory actually moves. You might be selling older stock while newer items stay on the shelves.

Which Method Is Right for You?

Think about the type of products you sell and how prices change.

If you deal with perishable items (like food or flowers) or your prices frequently change, LIFO might work better for you, especially during times of inflation. If your prices are stable and you want simpler inventory management, FIFO might be a better fit.

Each method has its pros and cons, so choose the one that best fits your business needs!

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!

Also Read:

1. Inventory Management: The Backbone of a Smooth-Running Business
2. A Guide to Managerial Accounting and the Ways It Can Streamline Your Business
3. The Complete Guide of Expense Recognition Principle
4. Consignment Agreements 101: A Guide for Sellers & Businesses
5. PM Gati Shakti: Benefits to Manufacturers, Businesses , CAs