FIFO Vs LIFO – Which Is The Best Inventory Valuation Method?

 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). These are two mostly used inventory methods for record keeping that are feasible on accounting standards.

Inventory accounting assigns values and revenue figures that helps one to take good business decisions for a long-term. It also helps to keep an eye on the accounting profit. Therefore, it becomes necessary to create a record containing 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 an 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.  LIFO method is like any store where the clerks stock the last item from front and customers purchase items from 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, it 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 company’s business as high cost inventory keeps adding up in the inventory totals for several years. Oldest inventory will always be held back the end of the list. These generally accepted accounting procedures use for accounting purposes help to keep an eye the current market prices and manage helps in manage the remaining balance sheet value. It also makes various warehouse operations easy.

Reasons of using LIFO method

The only reason for using LIFO 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 LIFO system, 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 the product unit cost. It also reduces high income tax expense.

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 LIFO Vs FIFO Method :

• During inflation environment, cost of goods is higher whereas remaining inventory balance in lower. Through LIFO, the main advantage lies in reporting lower profits, 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. It helps to validate the published financials and the income statement.
• LIFO is simple to understand, easy to operate among these inventory management systems.
• By moving high-cost inventories to cost of goods sold, businesses can lower their reported profit levels and defer income tax recognition for the total purchases.

Disadvantages Of Using LIFO Vs FIFO Method :

• Firstly, inventory valuation does not talk about current prices or key financial statements hence LIFO of no relevance, in assessing current situations and the total cost.

• It is more difficult and complex to maintain inventory cost accounting in this method. If most recent purchased inventories are always used as 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 keeps fluctuating. It might also cause a problem if there is an unusual increase in prices.

• Clerical work and inventory cost accounting is more in LIFO procedure. This might cause delays for financial accounting purposes.

• If businesses plan to expand globally, LIFO is definitely not the right choice for valuing company’s current assets or financial accounting.

 

 

Example of LIFO method

Using LIFO on the following information to calculate the value of ending inventory and the total cost of goods sold as 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

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 as the right way to value dynamic inventory. Also, it is more logical approach, as oldest goods get sold first, thereby reducing the risk of getting obsolete.

In the FIFO process, goods which 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, 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 cost of goods sold.

This gives an idea that gross margin doesn’t essentially reflect on matching the cost and revenue numbers. During inflationary environment, current-cost revenue is matched against older and low-cost inventory goods, which results in maximum gross margin. FIFO way of valuing inventory is accepted in international standards. It yields same results for both periodic and perpetual inventory system.

Advantages Of Using FIFO Vs LIFO Method  :

• It is more realistic and practical, compared to LIFO. Also, it’s simple and easy.

• The theory is based on the logic of selling those inventories which are first purchased. Therefore, companies issue materials and utilize the goods that are set at higher price 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 of more recent purchases, therefore closing stock of materials are valued at market price.

• 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 clearly 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 FIFO technique, cost of inventory is related to the cost of latest purchases, that is Rs.70.

Disadvantages Of Using FIFO Vs LIFO Method :

• 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 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 benefit. FIFO inventory valuation results in higher amount 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, and liquor beer or wine stores; you can preferably opt for LIFO method rather than FIFO.

In sectors like building products and hardware, steel product selling, electrical supply, farm and ranch supply stores ; Also in dollar stores, sporting goods store, apparel stores, electronic stores, furniture stores and grocery and food products distribution, LIFO is the best way of valuing your current assets.

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 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 small business or your 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 railway and banks also use 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 entire inventory cycle from purchase to sales.