Definition
FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are inventory valuation methods. FIFO assumes the first items added to an inventory are the first sold, so the remaining inventory consists of the most recently purchased items. In contrast, LIFO assumes the most recently added items are the first to be sold, leaving older inventory in stock.
Key Takeaways
- FIFO (First In, First Out) and LIFO (Last In, First Out) are two commonly used methods in inventory management and accounting. FIFO assumes that the first goods acquired are the first goods sold, whereas LIFO assumes that the last goods acquired are the first ones sold.
- The choice between FIFO and LIFO can significantly affect a company’s financial reporting. FIFO can result in higher profits during times of inflation since it assumes that older, cheaper goods are sold first. Conversely, LIFO can result in lower taxable income during inflation because it assumes that the newer, more expensive goods are sold first.
- A key component to remember is that while LIFO may reduce tax liabilities in an inflationary environment, some critics believe it can distort a company’s financial performance, making it appear less profitable than it is. On the other hand, FIFO provides a better indication of the value of the ending inventory on the balance sheet.
Importance
FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are important terms in finance and accounting that refer to methods used to account for changes in inventory over a certain period of time. This choice significantly affects the company’s reported profit, taxable income, and inventory valuation.
In the FIFO method, it is assumed that the oldest inventory items are sold first, which means the items left in inventory at the end of the year are the most recently purchased or produced. Conversely, LIFO assumes that the newest inventory items are sold first, meaning the items left at the end of the year are the oldest.
The choice between FIFO and LIFO can greatly impact a company’s financial statements, especially during periods of inflation or deflation, thus influencing the perceived financial performance and tax liability of the company. Therefore, businesses must choose carefully between FIFO and LIFO to accurately represent their financial health, as different methods are advantageous under different economic conditions and for different types of businesses.
Explanation
First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) are two critical inventory valuation methods that businesses use to manage costs and calculate profits in the field of finance. The purpose of both methods is to assign costs to goods or services and to accurately record and calculate profit and loss.
Deciding between FIFO and LIFO affects the gross margin, net income, and taxes of any business, influencing its overall financial standing. In a rising price environment, the FIFO method, which assumes the first goods purchased or manufactured are also the first to be sold, often results in a smaller cost of goods sold (COGS) and therefore, a higher profit compared to LIFO.
Conversely, LIFO, which assumes the most recently acquired goods are sold first, generally results in lower net income and lower tax payments in a rising price market. Hence, the decision between using FIFO or LIFO is strategic and depends on the objectives of the company from the financial perspective.
Examples of FIFO vs LIFO
Retail Business: Imagine two retailers who start a business with a stock of 100 shirts at $10 each. Over time, they both buy additional 50 shirts at $
According to the FIFO (First In, First Out) method, the first business would sell the initial 100 shirts before selling the new ones, considering the cost of goods sold (COGS) to be $10/shirt. However, under the LIFO (Last In, First Out) method, the second business would first sell the newly purchased shirts with a COGS of $15/shirt. This discrepancy would result in different gross profit margins and taxable income between the two businesses.
Oil and Gas Industry: In this industry, companies often use the LIFO method because oil and gas prices are usually rising. As a result, companies can sell the most recently extracted (more expensive) resources first, which allows them to have higher COGS and lower taxable income. In contrast, if a company used the FIFO method, it would sell the oldest (cheaper) resources first, yielding a lower COGS and higher taxable income.
Grocery Stores: Most grocery stores use the FIFO inventory method to guarantee that perishable products do not expire on the shelves. For instance, if they get a fresh delivery of milk, they place the new containers behind the old ones, so that they sell off the older stock first (FIFO), ensuring the milk is always fresh for customers. If they were to use LIFO, they would put fresh deliveries in the front, leaving the older stock at the back, potentially resulting in spoiled inventory.
FAQs: FIFO vs LIFO
What is FIFO?
FIFO stands for “First in, First out.” It is an inventory management method where the goods that are received or produced first are the first to be sold. It assumes that the oldest products will be sold first, not necessarily that the exact oldest items are being sold.
What is LIFO?
LIFO stands for “Last in, First out.” It is an inventory management strategy where the most recently produced or purchased items are the ones sold first. This method assumes that the newest inventory is sold first.
What are the main differences between FIFO and LIFO?
The main difference between FIFO and LIFO is the order in which transactions are recorded. With FIFO, it is assumed that the oldest inventory items are sold first. This means that the cost of the oldest inventory is used to calculate the cost of goods sold. On the other hand, LIFO assumes that the newest inventory items are sold first, meaning the cost of the newest inventory is used in the cost of goods sold calculation.
When is it better to use FIFO?
FIFO is usually better for businesses that sells perishable goods, have goods that get obsolete quickly, or where the cost of storage is high and older goods need to be sold first. It also more accurately reflects the natural flow of inventory for most businesses.
When is it better to use LIFO?
LIFO is generally better for businesses during periods of inflation, as it helps to reduce a company’s tax liabilities. LIFO is beneficial for businesses where items do not have an expiry and do not become obsolete.
Related Entrepreneurship Terms
- Inventory Management
- Cost of Goods Sold (COGS)
- Gross Margin
- Balance Sheet
- Income Statement
Sources for More Information
- Investopedia: An extensive source for easy-to-understand financial education.
- AccountingTools: Provides comprehensive resources about accounting principles and practices.
- The Balance: A trustworthy site focusing on practical financial advice and education.
- The Motley Fool: A privately held financial and investing advice company.
