How can you compare FIFO and LIFO inventory methods?

1 What are FIFO and LIFO?

FIFO and LIFO are inventory control methods that determine which items are sold first and which are left in stock. FIFO assumes that the oldest items are sold first, while LIFO assumes that the newest items are sold first. For example, if you sell apples and you buy 10 apples for $1 each on Monday and 10 apples for $2 each on Tuesday, FIFO would assign the cost of $1 to each of the first 10 apples sold, while LIFO would assign the cost of $2 to each of the first 10 apples sold.

2 How do FIFO and LIFO affect inventory value?

The choice of FIFO or LIFO affects the value of your inventory on your balance sheet. FIFO results in a higher inventory value, because the older items are usually cheaper than the newer items. LIFO results in a lower inventory value, because the newer items are usually more expensive than the older items. For example, using the same apple scenario, if you sell 15 apples by the end of the week, FIFO would value your remaining inventory at $10 (5 apples x $2), while LIFO would value your remaining inventory at $5 (5 apples x $1).

3 How do FIFO and LIFO affect income statement?

The choice of FIFO or LIFO also affects your income statement, which shows your revenue, cost of goods sold, and gross profit. FIFO results in a lower cost of goods sold and a higher gross profit, because you sell the cheaper items first. LIFO results in a higher cost of goods sold and a lower gross profit, because you sell the more expensive items first. For example, using the same apple scenario, if you sell 15 apples for $3 each, FIFO would report a cost of goods sold of $15 (10 apples x $1 + 5 apples x $2) and a gross profit of $30 (15 apples x $3 - $15), while LIFO would report a cost of goods sold of $25 (10 apples x $2 + 5 apples x $1) and a gross profit of $20 (15 apples x $3 - $25).

4 How do FIFO and LIFO affect cash flow?

The choice of FIFO or LIFO also affects your cash flow, which shows how much money you have available to pay your expenses and invest in your business. FIFO results in a higher cash flow, because you pay less tax on your higher gross profit. LIFO results in a lower cash flow, because you pay more tax on your lower gross profit. For example, using the same apple scenario, if you pay a 20% tax rate on your gross profit, FIFO would result in a cash flow of $24 ($30 x 0.8), while LIFO would result in a cash flow of $16 ($20 x 0.8).

5 What are the advantages and disadvantages of FIFO and LIFO?

The choice of FIFO or LIFO depends on your business goals, industry, and market conditions. FIFO matches the physical flow of goods, reflects the current market value of inventory, and increases cash flow. However, it also inflates gross profit, exposes you to higher tax liability, and may not match the actual cost of production. On the other hand, LIFO matches the actual cost of production, reduces tax liability, and protects you from inflation. Yet it distorts inventory value, decreases cash flow, and may not match the physical flow of goods.

6 How can you choose the best method for your business?

When deciding which inventory method is best for your business, you should take several factors into account. These include the nature of your products, the price trend of your products, and the accounting standards and regulations that apply to your business. For example, if your products are perishable or seasonal, FIFO may be more suitable. On the other hand, if your products have a rising price trend, FIFO may be better to avoid overstatement of cost of goods sold and underpayment of taxes. Additionally, if you operate in the US, you can choose either FIFO or LIFO, but must follow the IRS rules. However, if you operate in other countries, you may not be allowed to use LIFO as it is prohibited by the International Financial Reporting Standards (IFRS).

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?