Inventory Management Methods: FIFO vs. LIFO (2024)

  • FIFO (first in, first out) inventory management seeks to value inventory so the business is less likely to lose money when products expire or become obsolete.
  • LIFO (last in, first out) inventory management is better for nonperishable goods and uses current prices to calculate the cost of goods sold.
  • Both U.S. and international standards are moving away from LIFO and toward FIFO or dollar-cost averaging.
  • This article is for small business owners who want to learn about inventory valuation methods.

Inventory management is a crucial function for any product-oriented business. First in, first out (FIFO) and last in, first out (LIFO) are two standard methods of valuing a business’s inventory. Your chosen system can profoundly affect your taxes, income, logistics and profitability.

We’ll explore how both methods work and how they differ to help you determine the best inventory valuation method for your business.

Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.

What is FIFO, and how does it work?

Companies that operate on the principle of first in, first out value inventory on the assumption that the first goods the business manufactures or purchases should become the first goods sold. (This may not be true in some instances, as some companies stock both new and old items.)

Due to economic fluctuations and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered more profitable – at least on paper. Companies that sell perishable products or units subject to obsolescence, such as food products or designer fashions, commonly follow the FIFO inventory valuation method.

For example, a grocery store purchases milk regularly to stock its shelves. As customers purchase milk, stockers push the oldest product to the front and add newer milk behind those cartons. Milk cartons with the soonest expiration dates are the first ones sold; cartons with later expiration dates are sold after the older ones. This process ensures that older products are sold before they perish or become obsolete, thereby avoiding lost profit.

Anil Melwani, CPA and partner at New York accounting firm Tanton Grubman CPAs LLP, said that because prices rise in the long term, a business’s accounting method choice can significantly affect valuations.

“FIFO gives us a better indication of the value of ending inventory on the balance sheet, but it also increases net income because inventory that might be several years old is used to value the cost of goods sold,” Melwani said. “Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay.”

FIFO is an ideal valuation method for businesses that must impress investors – until the higher tax liability is considered. Because FIFO results in a lower recorded cost per unit, it also records a higher level of pretax earnings. And with higher profits, companies will likewise face higher taxes.

Tip

Inventory management software can help you keep an accurate inventory count, which is critical to a business’s bottom line. Read our reviews of the best inventory management software to find a solution for your company.

How to calculate FIFO

To calculate the cost of goods sold (COGS) under FIFO, begin by determining the cost of your oldest inventory, said Stephanie Ng, a CPA and founder of the CPA exam preparation website I Pass the CPA Exam. “Then, multiply this cost by the number of inventory items sold to determine the costs associated with the sale of inventory using FIFO.”

For the purposes of this calculation and the ones that follow, we’ll focus on periodic FIFO. Here is Ng’s sample formula:

Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold ($X,XXX)

“You can change the order of this equation to solve for the ending inventory,” Ng said. “So, ending inventory using the FIFO method is the goods available for sale less the costs of goods sold. When a physical inventory count hasn’t occurred, this can be used to back the ending inventory amount.”

Example of FIFO

Once you understand what FIFO is and what it means for your business, it’s crucial to learn how it works. Ng offered an example of FIFO using real numbers to show the formula in action.

“Suppose Candle Corporation is in its first year of operations, and they purchased two batches of inventory throughout the year,” she said. “Batch 1 was for 3,000 units at $1.25 per unit. Batch 2 was for 6,000 units at $1.75 per unit. Seven thousand units were sold in total. Two thousand units were sold after the first purchase, [and] 5,000 units were sold after the second purchase. To calculate ending inventory and costs of goods sold using FIFO in a periodic inventory system, start by calculating goods available for sale.”

Using this example and the above formula, this is how Candle Corporation would calculate its goods available for sale:

Beginning inventory ($0) + Batch 1 purchases (3,000 units @ $1.25 each: $3,750) + Batch 2 purchases (6,000 units @ $1.75 each: $10,500) = Goods available for sale ($14,250)

“Ending inventory isn’t given in this scenario, so you can use the cost of goods sold to ‘squeeze’ out this value,” Ng explained. “Under FIFO, you need to first account for selling your oldest inventory. In this case, Batch 1 is the oldest, so we want to first use up all that inventory. Then, the remainder will come from Batch 2. Keep in mind that 7,000 units in total were sold.”

Here’s how Ng calculated the total cost of goods sold using periodic FIFO:

COGS from Batch 1 (3,000 units @ $1.25 each: $3,750) + COGS from Batch 2 (4,000 units @ $1.75 each: $7,000) = Total COGS ($10,750)

Now, you can calculate the ending inventory:

Goods available for sale ($14,250) – COGS ($10,750) = Ending inventory ($3,500)

“When determining the cost of goods sold or ending inventory using periodic FIFO, it doesn’t matter when the inventory was sold,” Ng said. “It’s just important to use up the oldest inventory first.”

Key Takeaway

The goal of the FIFO inventory management method is to reduce inventory waste by selling older products first.

What is LIFO, and how does it work?

The last in, first out inventory method uses current prices to calculate the cost of goods sold instead of what you paid for the inventory already in stock. If the price of goods has increased since the initial purchase, the cost of goods sold will be higher, thus reducing profits and tax liability. Nonperishable commodities (like petroleum, metals and chemicals) are frequently subject to LIFO accounting when allowed.

“LIFO isn’t a good indicator of ending inventory value because the leftover inventory might be extremely old and, perhaps, obsolete,” Melwani said. “This results in a valuation much lower than today’s prices. LIFO results in lower net income because the cost of goods sold is higher, so there is a lower taxable income.”

Reduced tax liability is a key reason some companies prefer LIFO. “By using more recent inventory in valuation, your cost basis is higher on current income statements,” Melwani said. “This reduces gross profit and, ultimately, net income. This is the implication of LIFO, and many companies prefer LIFO because lower profit reporting means a reduced tax burden.”

How to calculate LIFO

Ng offered a formula for calculating LIFO. We will again focus on periodic LIFO for this and the following formulas. According to Ng, much of the process is the same as it is for FIFO, including this basic formula. She noted that the differences come when you’re determining which goods you’re going to say you sold.

Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold

Example of LIFO

Suppose a website development company purchases a plugin for $30 and then sells the finished product for $50. Then, several months later, the plugin price increases to $35. When the company calculates its profits, it would use the most recent price of $35. In tax statements, it would appear that the company made a profit of only $15.

By using LIFO, a company would appear to be making less money than it actually did and, therefore, have to report less in taxes.

Ng offered another example, revisiting the Candle Corporation and its batch-purchase numbers and prices. First, we’ll calculate the total cost of goods sold.

“Under LIFO, you need to account for selling your newest inventory first. Because Batch 2 was purchased more recently, you want to use up that inventory first,” Ng explained. “Only 6,000 units were purchased in Batch 2, but 7,000 units were sold. That means you should use up the 6,000 first, and then use the remaining 1,000 units sold from Batch 1.”

For the sake of simplicity, Ng kept the purchase prices the same and didn’t determine if the current price was higher or lower. Here are the numbers in action:

COGS from Batch 2 (6,000 units @ $1.75 each: $10,500) + COGS from Batch 1 (1,000 units @ $1.25 each: $1,250) = Total COGS ($11,750)

Now, we’ll need to calculate the ending inventory:

Goods available for sale ($14,250) – COGS ($11,750) = Ending inventory ($2,500)

The principle of LIFO is highly dependent on how the price of goods fluctuates based on the economy. If a company holds inventory for a long time, it may prove quite advantageous in hedging profits for taxes. LIFO allows for higher after-tax earnings due to the higher cost of goods. At the same time, these companies risk that the cost of goods will go down in the event of an economic downturn and cause the opposite effect for all previously purchased inventory.

Key Takeaway

LIFO inventory management allows businesses with nonperishable inventory to take advantage of price increases on newer stock. On their accounting reports, they can calculate a higher cost of goods sold and then report less profit on their taxes.

Restrictions on the use of LIFO

LIFO is banned by International Financial Reporting Standards (IFRS), a set of common rules for accountants who work across international borders. While many nations have adopted IFRS, the United States still operates under the guidelines of generally accepted accounting principles (GAAP). If the United States were to ban LIFO, the country would clear an obstacle to adopting IFRS, thus streamlining accounting for global corporations.

Because of the current discrepancy, however, U.S.-based companies that use LIFO must convert their statements to FIFO in their financial statement footnotes. This difference is known as the “LIFO reserve.” It’s calculated between the cost of goods sold under LIFO and FIFO. This increases the comparability of LIFO and FIFO firms.

In general, both U.S. and international standards are moving away from LIFO. Many U.S.-based companies have switched to FIFO. Some companies still use LIFO within the United States for inventory management but translate it to FIFO for tax reporting. Only a few large companies within the United States can still use LIFO for tax reporting.

Some companies believe repealing LIFO would result in a tax increase for both large and small businesses, though many other companies use FIFO with few financial repercussions.

“While it’s up to management to choose the most appropriate cost flow assumption, FIFO best reflects the physical flow of inventory,” Ng said. “Management should consider the business’s model, tax implications and international financial requirements (if any) before choosing LIFO or FIFO.”

Key Takeaway

Although LIFO falls under GAAP, it’s banned under international accounting standards. U.S. businesses are moving away from LIFO; those that use it for inventory management may still use FIFO for tax reporting.

FIFO and LIFO similarities and differences

FIFO and LIFO are very different inventory management techniques. However, they are similar in one regard: Both depend on the product remaining the same, with the company’s cost basis (its manufacturing cost or acquisition price) being the only fluctuating element.

FIFO and LIFO influence a company’s earnings on paper. Here are the key differences:

  • FIFO is most successful in industries where a product’s price remains steady and the company sells its oldest products first. That’s because FIFO is based on the cost of the first goods purchased, ignoring any increases or reductions in price for newer units.
  • LIFO works well in industries where prices fluctuate and the newest units are sold first. “Because FIFO results in a higher net income during periods of rising prices, it also results in higher income tax expenses,” Ng said. “Conversely, if the LIFO method is used during a period of rising prices, it will result in lower net income. So, this method would result in a lower income tax expense.”

Another difference is that FIFO can be utilized for both U.S.- and internationally based financial statements, whereas LIFO cannot.

Tip

Whether you use FIFO or LIFO, you’ll need accounting software to track your finances and make accurate calculations. Check out our reviews of the best accounting software to record and report your business’s financial transactions.

Implementing FIFO or LIFO in your business

While FIFO and LIFO sound complicated, they’re very straightforward to implement. The best POS systems will include inventory tracking and inventory valuation features, making it easy for business owners and managers to choose between LIFO and FIFO and use their chosen method.

If you’re unclear on whether FIFO or LIFO is better for your business (though LIFO is increasingly rare, as it’s prohibited by some accounting standards), an inventory management tool can help you compare the impacts of FIFO and LIFO on your bottom line.

Of course, choosing between LIFO and FIFO isn’t a lifetime commitment. Even if you’ve been using one or the other for years, you can always change methods, though you should seek the guidance of a CPA during this somewhat complicated process.

FIFO and LIFO alternatives

In addition to FIFO and LIFO, which are historically the two most standard inventory valuation methods because of their relative simplicity, there are other methods. The most common alternative to LIFO and FIFO is dollar-cost averaging.

Dollar-cost averaging involves averaging the amount a company spent to manufacture or acquire each existing item in the firm’s inventory. As inventory is sold, the basis for those items is assumed to be the average inventory cost at the time of their sale. Then, as new items are added to the company’s inventory, the average value of items in the firm’s updated inventory is adjusted based on the prices paid for newly acquired or manufactured items.

Did You Know?

POS sales reports can help you make informed inventory decisions and compare sales from different store locations.

Why inventory valuation matters

Inventory valuation can be tedious if done by hand, though it’s essentially automated with the right POS system. Although picking which method to use may seem trivial, the subtle differences between FIFO and LIFO inventory management can add up to thousands of dollars (or even more for large companies) of tax savings each year.

That’s why it’s essential to track your business’s inventory carefully while identifying and implementing the best inventory valuation method to maximize your net profit each year and minimize your tax burden from sales.

Dock Treece, Jennifer Post and Ryan Goodrich contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.

Inventory Management Methods: FIFO vs. LIFO (2024)

FAQs

Inventory Management Methods: FIFO vs. LIFO? ›

FIFO means the first items we got are the first we sell. This can mean lower costs and more profit when prices go up. LIFO, however, sells the newest items first. This leads to higher costs and less profit in the same situation.

Which method is better FIFO or LIFO? ›

In most cases, FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods. LIFO, on the other hand, is only strategically valuable during times of inflation, as goods sold first are also typically the most expensive.

Why would management prefer to use LIFO over FIFO? ›

In terms of tax purposes, FIFO usually results in a higher tax bill because the inventory that is sold first is usually the most expensive. US companies may prefer LIFO when prices rise because it gives them the highest cost of goods sold and the lowest taxable income.

How do you solve for FIFO and LIFO? ›

To calculate FIFO (First-In, First Out) determine the cost of your oldest inventory and multiply that cost by the amount of inventory sold, whereas to calculate LIFO (Last-in, First-Out) determine the cost of your most recent inventory and multiply it by the amount of inventory sold.

What's the difference between LIFO and FIFO Can you walk me through an example of how they differ? ›

The FIFO method assumes that the oldest inventory units are sold first, while the LIFO method assumes that the most recent inventory units are sold first. FIFO tends to reflect current market prices better. LIFO better matches current costs with revenue and provides a hedge against inflation.

Why LIFO is banned? ›

IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete.

Why is LIFO the best method? ›

The most noteworthy advantages of LIFO include: Tax savings. If the cost of your products increases over time, the LIFO method can help you save on taxes. This is because applying the most recent or higher inventory costs to the items you've sold will cause your profit margin to go down.

What are the 5 disadvantages of FIFO? ›

Disadvantages of FIFO
  • Unsuitable for volatile pricing. The FIFO method is not a suitable measure when you have inventory purchases or production with fluctuating prices. ...
  • More complex than LIFO. ...
  • Many factors affect inventory valuation.
May 29, 2023

Does Walmart use LIFO or FIFO? ›

Walmart does not utilize the Last-In, First-Out (LIFO) inventory costing method. Instead, it primarily uses the First-In, First-Out (FIFO) method. The LIFO reserve represents the difference between the cost of inventory calculated under the LIFO method and the cost calculated under an alternative method like FIFO.

What are the disadvantages of LIFO? ›

However, this accounting method carries a distinct disadvantage. When a company follows the LIFO method, the ending inventory is valued at old prices. These don't reflect the current situation. Consequently, the financial statements could present a distorted picture of the value of a company's inventory.

What is FIFO and LIFO for dummies? ›

The Last-In, First-Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first. The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.

What is an example of a LIFO problem? ›

Insight on LIFO Method Example

If 80 loaves were sold using LIFO, the first 50 would come from the second (latest) purchase costing $2 each, and 30 would come from the first purchase costing $1 each. Therefore, the total cost of goods sold would be 50 loaves * $2 + 30 loaves * $1.

How to find COGS using LIFO? ›

To calculate COGS, it would take into account the newest purchase prices.
  1. COGS = (The Number of Newest Units x Their Value) + (Remaining Units From the Second Purchase x Their Value) ...
  2. Ending Inventory Value = Remaining Units x Their Value. ...
  3. COGS = The Number of Newest Units x Their Value.
Aug 14, 2023

In what situation would you use LIFO? ›

During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO, firms can save on taxes as well as better match their revenue to their latest costs when prices are rising.

What is an example of LIFO method in real life? ›

Example: Let's say a business bought 100 shares of stock at $10 each and 100 shares at $20 each. If the business sells 100 shares of stock at $25 each, the cost basis using the HIFO method would be $20 per share. This reduces the amount of taxable income and saves the business money on taxes.

How to tell if a company uses FIFO or LIFO? ›

FIFO represents First In First Out, where the commodities and services acquired first in the firm are disposed of to the market. In contrast, LIFO represents Last In First Out, where commodities and services acquired lastly in the firm are disposed of first within during sales in the business.

Why is FIFO the best method? ›

It aligns the current costs of the business with the actual flow of goods or inventory out of the business more accurately than any other method. This leads to better accounting and more real-time analysis on where the business stands if it has a heavy amount of inventory.

Is LIFO or FIFO better for food? ›

For perishable goods or products with a life cycle or life span, it always has to be FIFO - or you'll lose money. For other products, you might need to get together with your accountant or whoever takes care of the finances to work out if LIFO is the best way to move stock in and out of your warehouse.

Is LIFO or FIFO more aggressive? ›

In a market where prices are rising, using FIFO is better, as it reduces the cost of goods sold and increases earnings. Therefore, it may be said that FIFO is a more aggressive method than LIFO in this case only.

Which inventory costing method is best? ›

First-in, first-out (FIFO)

This method can result in a more accurate reflection of the current inventory cost, as the price of the oldest items may be lower than that of newer items.

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