FIFO vs. LIFO Inventory Valuation

Introduction

All companies must determine how to record the movement of their inventory. The amount a company pays for raw materials, labor, and overhead costs is continually changing. For this reason, the amount it costs to make or buy a good today might be different than one week ago. 

For many companies, inventory represents a large, if not the largest, portion of their assets. As a result, inventory is a critical component of the balance sheet. Serious investors must understand how to assess the inventory line item when comparing companies across industries—or companies in their own portfolios.

Key Takeaways

• The last-in, first-out (LIFO) method assumes that the last unit to arrive in inventory is sold first.

• The first-in, first-out (FIFO) method assumes that the oldest unit of inventory is sold first.

• LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock.

• FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.

• Deciding between these two inventory methods has implications for a company's financial statements as this decision impacts the value of inventory, cost of goods sold, and net profit.

Understanding Different Inventory Accounting Methods

Inventory refers to a company's goods in three stages of production:

• Raw materials are basic goods used in production to generate finished products.

• Work-in-progress are goods being manufactured but not yet complete.

• Finished inventory is goods ready for sale that can be bought and delivered to consumers.

You can take the goods that the company has at the beginning of any given period, add the materials that it purchased to make more goods, subtract the goods that the company sold—also called cost of goods sold (COGS)—and the result is the company's ending inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets because inventory can be sold—thus turning it into cash in the future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

Beginning Inventory I+ Net Purchases − COGS = Ending Inventory

There are different inventory accounting methods, including first in, first out (FIFO) and last in, first out (LIFO). Companies often try to match the physical movement of inventory to the inventory method they use. The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements: balance sheet, income statement, and statement of cash flows.

First In, First Out (FIFO)

The first in, first out (FIFO) method assumes that the first unit making its way into inventory–the oldest inventory–is sold first. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each and produces 200 more on Tuesday at $1.25 each. According to the rules of FIFO, if the bakery sells 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory on the balance sheet.

Last-In, First-Out (LIFO)

The last-in, first-out (LIFO) method assumes that the last unit making its way into inventory–the newest inventory–is sold first. Therefore, the older inventory is left over at the end of the accounting period. Now, suppose the scenario is the same for this bakery—it produces 200 loaves of bread on Monday at a cost of $1 each and produces 200 more on Tuesday at $1.25 each. If the bakery sells 200 loaves on Wednesday, the COGS—on the income statement—is $1.25 per loaf. The $1 loaves would be allocated to ending inventory on the balance sheet.

LIFO vs. FIFO: Inventory Valuation

LIFO

Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete. As a result, LIFO doesn't provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today's prices. Also, LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock while using the most recently acquired inventory.

For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products. In other words, the seafood company would never leave their oldest inventory sitting idle since the food could spoil and lead to losses.

LIFO isn't practical for many companies that sell perishable goods and doesn't accurately reflect the logical production process of using the oldest inventory first.

FIFO

FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most recently acquired items reflect current market prices. For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.

For example, the seafood company—from the earlier example—would use their oldest inventory first (or first in) when selling and shipping their products. Because the seafood company would never leave older inventory in stock (because it could spoil), FIFO accurately reflects the company's process of using the oldest inventory first in selling their goods.

LIFO vs. FIFO: Impact of Inflation

If inflation were nonexistent, then all inventory valuation methods would produce the same results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, the bakery from our earlier example would be able to produce all of its bread loaves at $1, and LIFO and FIFO would both give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period.1

Assuming that prices are rising, inflation would impact LIFO and FIFO as follows:

LIFO

When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from a lower tax liability.

FIFO

When sales are recorded using the FIFO method, the oldest inventory—that was acquired first—is used up first. FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old—which was acquired for a lower cost—is used to value COGS. However, the higher net income means the company would have a higher tax liability.

LIFO vs. FIFO: Financial Reporting

LIFO

Companies outside of the United States that must adhere to International Financial Reporting Standards (IFRS) are not permitted to use the LIFO method.2 Public companies in the U.S. are required to adhere to the generally accepted accounting principles (GAAP)—accounting standards set forth by the Financial Accounting Standards Board (FASB). GAAP permits the use of LIFO and FIFO.3

Though the LIFO inventory method does require a robust inventory management system to track different inventory transactions, LIFO systems often require less demand on historical data because the most recent purchases are sold first. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method; once early inventory is booked, it may remain on the books untouched for long periods of time.

FIFO

In addition to being allowable by both IFRS and GAAP users, the FIFO inventory method may require greater consideration when selecting an inventory method. Companies that undergo long periods of inactivity or accumulation of inventory will find themselves needing to pull historical records to determine the cost of goods sold. Though many accounting systems can automate this process, the bookkeeping requirements under the FIFO method result in transactions that continually turn over and do not remain on the books for as long (compared to the LIFO method).

LIFO vs. FIFO: Taxes

LIFO

During a period of rising prices, the most expensive items are sold with the LIFO method. This means the value of inventory is minimized, and the value of COGS is increased. Under the LIFO method, expenses are highest. So taxable net income is lower under the LIFO method, as is the resulting tax liability.

FIFO

In contrast, taxes are usually higher using the FIFO method. Assuming that prices are rising, this means that inventory levels are going to be highest because the most recent goods (often the most expensive) are being kept in inventory. This also means that the earliest goods (often the least expensive) are reported under the COGS. Because the expenses are usually lower under the FIFO method, net income is higher—resulting in a potentially higher tax liability.

LIFO and FIFO: Advantages and Disadvantages

When a company selects its inventory method, there are downstream repercussions that impact its net income, balance sheet, and its requirements for tracking inventory. The pros and cons listed below assume the company is operating in an inflationary period of rising prices.

LIFO

Assuming that prices tend to rise over an accounting period, the LIFO method results in a lower value for the cost of goods sold (COGS), resulting in a lower tax liability at the end of the accounting period. It may also be easier to implement if recently-purchased inventory is more accessible.

However, the LIFO method may not represent the actual movement of inventory. Many companies try to move older inventory first. Depending on the actual shelf life, this may not reflect the real value of the company's inventory.

FIFO

While LIFO produces a lower tax liability, the FIFO method tends to report a higher net income, which can make the company more attractive to shareholders. It also reports a higher value for current inventory, which can strengthen the company's balance sheet.

However, if inventory has been stagnant for some time, this method may not reflect the actual cost of materials, especially in an inflationary environment.

LIFO

• Results in lower tax liability compared to other methods

• May be easiest to implement if inventory is easily accessible because it has been recently purchased

  
  

• Often does not represent the actual movement of inventory (i.e., many companies try to move older inventory)

• Results in lower net income compared to other methods

  
  

FIFO

• Results in higher net income compared to other methods

• Often results in higher inventory balances compared to other methods, strengthening a company's balance sheet

• Results in a higher tax liability compared to other methods.

• May not accurately communicate the true cost of materials if inventory has been stagnant while prices are rising.

  
  

LIFO or FIFO: Which One Is Best?

The difference between $8,000, $15,000, and $11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics: for example, factors that expose a company's current financial health and enable us to make projections about its future. The inventory figure a company starts with when valuing its inventory matters. And, companies are required by law to state which accounting method they use in their published financials.

Although the ABC Company example above is fairly straightforward, the subject of inventory—and whether to use LIFO or FIFO—can be complex. Knowing how to manage inventory is critical for all companies, no matter their size. It is also a major success factor for any business that holds inventory because it helps a company control and forecast its earnings. For investors, inventory is an important item to analyze because it can provide insight into what's happening with a company's core business.

Major Differences—LIFO and FIFO (During Inflationary Periods)

LIFO

• The newest inventory item is the first item to be sold.

• Net income is often lower.

• Cost of goods sold is often higher.

• Ending inventory on the balance sheet is often lower.

• LIFO often does not represent the actual movement of inventory (because companies try to sell the items at the most risk of obsolescence).

FIFO

• The oldest inventory item is the first to be sold.

• Net income is often higher.

• Cost of goods sold is often lower.

• Ending inventory on the balance sheet is often higher.

• FIFO more closely represents the actual movement of inventory (because companies try to sell the items at the most risk of obsolescence).

  
  

Is FIFO a Better Inventory Method Than LIFO?

FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this also results in higher tax liabilities and potentially higher future write-offs—in the event that that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory.

Does IFRS Permit LIFO?

No, the LIFO inventory method is not permitted under international financial reporting standards (IFRS). Both the LIFO and FIFO methods are permitted under generally accepted accounting principles (GAAP).

What Types of Companies Often Use LIFO?

Companies often use LIFO when attempting to reduce their tax liability. LIFO usually doesn't match the physical movement of inventory because companies are more likely to try to move older inventory first. However, car dealerships or oil companies may try to sell items marked with the highest cost to reduce their taxable income.

What Types of Companies Often Use FIFO?

Companies with perishable goods—or items heavily subject to obsolescence—are more likely to use FIFO. For example, consider a grocery store selling produce: that grocery store is more likely to sell older bananas as opposed to the most recently delivered inventory. If the store sells the most recent inventory it receives, the oldest inventory items will likely go bad.

In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. For example, a chip manufacturer may want to ensure older units of a specific model are moved out of inventory; more recently manufactured units of the same model may be able to better withhold storage conditions.

The Bottom Line

Companies can choose between different accounting inventory methods, including LIFO and FIFO. Companies that opt for the LIFO method sell their most recent inventory first, which usually costs more to obtain or manufacture. The FIFO method results in a lower COGS and higher inventory. A company's taxable income, net income, and balance sheet are all impacted by its choice of inventory method.

Dr. Lovett has 30+ years experience in the accounting and finance fields. He is a noted author, columnist, speaker, and contributor to the financial success of multiple businesses and nonprofit organizations. Dr. Lovett can be contacted at dr.lovett@fl-business-consultants.com.