What is FIFO vs LIFO? What are the Advantages?

Managing inventory effectively is vital for any business, particularly when dealing with fluctuating costs. Two primary methods—FIFO (First-In, First-Out) and LIFO (Last-In, First-Out)—help businesses determine the cost of goods sold (COGS) and the value of remaining inventory. This article will explain what FIFO and LIFO are, how they work, their benefits, and when to use each method.

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What is FIFO, and how Does it Work?

FIFO stands for "First-In, First-Out." This method assumes that the oldest inventory items are sold first, much like how a grocery store prioritizes selling milk that is closest to its expiration date. As a result, the cost of the oldest inventory is recorded as the cost of goods sold (COGS), while the remaining inventory is valued at the cost of the most recently purchased items.

How does FIFO work? FIFO works by tracking the cost of each inventory batch purchased. When a sale occurs, the cost of the oldest batch is assigned to the cost of goods sold (COGS). The process continues with the next oldest batch being used, until all inventory from that batch has been sold.

How to use the FIFO method: The FIFO (First-In, First-Out) method is an inventory costing approach that assumes the oldest inventory items are sold first. This means the cost of the oldest inventory is applied to calculate the cost of goods sold (COGS), while the cost of the most recent inventory is used to value the remaining inventory.

To use the FIFO method, you need to track your inventory purchases, recording the date, quantity, and cost per unit for each batch. When a sale occurs, you assign the cost of the oldest inventory to the cost of goods sold (COGS). This process continues until all sold units are accounted for. The remaining inventory is then valued based on the cost of the most recent purchases.

What is LIFO, and How Does it Work?

LIFO stands for "Last-In, First-Out." This method assumes that the newest inventory items are sold first. Think of a bin of sand: it’s easiest to scoop from the top, which represents the most recently added sand. As a result, the cost of the newest inventory is assigned to the cost of goods sold (COGS), while the remaining inventory is valued at the cost of the oldest items.

What are LIFO and FIFO? Both LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) are inventory costing methods used to determine the cost of goods sold (COGS) and the value of ending inventory. They are contrasting approaches, each affecting financial reporting and tax calculations in different ways.

How to Use the LIFO Method? The LIFO (Last-In, First-Out) method is an inventory costing approach that assumes the most recently purchased items are sold first. This means the cost of the most recent purchases is used to calculate the cost of goods sold (COGS), while the cost of the oldest inventory is used to value the remaining stock.

To use the LIFO method, track your inventory purchases by recording the date, quantity, and cost per unit. When a sale occurs, assign the cost of the most recent inventory purchases to the cost of goods sold (COGS). Continue this process until all units sold have been accounted for. The remaining inventory will then be valued based on the cost of the oldest stock.

FIFO and LIFO Similarities and Differences

Similarities:

Both are inventory costing methods.
Both are used to calculate COGS and ending inventory value.
Both are acceptable accounting methods under certain accounting standards (though LIFO is not permitted under IFRS).

Differences:

Cost Flow Assumption: FIFO assumes the oldest items are sold first, while LIFO assumes the newest items are sold first.
Impact on COGS: In periods of rising prices, LIFO results in a higher COGS compared to FIFO.
Impact on Ending Inventory: In periods of rising prices, LIFO results in a lower ending inventory value compared to FIFO.
Tax Implications: In some jurisdictions, LIFO can lead to lower taxable income during inflationary periods due to the higher COGS.

What is The FIFO method?

What is FIFO method? The FIFO method is a cost flow assumption, meaning it's a way to assume how inventory moves, not necessarily how it physically moves. While the oldest items may not always be sold first in reality, FIFO assumes they are for the purpose of costing.

What is The LIIFO method?

The LIFO method, like FIFO, is a cost flow assumption. It assumes that the most recent purchases are sold first, regardless of the actual physical movement of goods.

Advantages of FIFO

Reflecting the Actual Flow: FIFO typically aligns more closely with the actual physical movement of goods, especially for perishable items.

Better Representation of Ending Inventory: FIFO typically leads to an ending inventory value that more closely reflects current market prices.

Simpler to Understand: FIFO is generally easier to understand and implement than LIFO.

Advantages of LIFO

Tax Advantages (in some jurisdictions): In times of inflation, LIFO can result in higher COGS, which leads to lower taxable income.

Matching Principle: LIFO matches the most recent costs with the most recent revenues, which some argue provides a better picture of current profitability.

When to Use FIFO and LIFO?

FIFO: Ideal for businesses dealing with perishable goods, those with high inventory turnover, and companies looking for a simpler inventory costing method.

LIFO: Potentially suitable for businesses operating in industries with volatile prices, where minimizing tax liability during inflation is a primary concern (where allowed).

How to Calculate LIFO?

Calculating LIFO involves determining the cost of the most recently purchased items and applying that cost to the units sold. For example, if you sold 100 units and your last purchase was 80 units at $10 each, and the purchase before that was 50 units at $8 each, your COGS would be (80 units * $10) + (20 units * $8).

How to Calculate FIFO?

Calculating FIFO involves identifying the cost of the oldest purchased items and assigning that cost to the units sold. For example, if you sold 100 units and your first purchase was 60 units at $5 each, and the purchase after that was 70 units at $7 each, your COGS would be (60 units * $5) + (40 units * $7). This calculation is based on the order in which inventory was acquired, meaning that the first items purchased are the first ones to be sold. This method assumes that the oldest stock, which was purchased first, is used up or sold before newer inventory. It helps businesses manage their inventory flow by aligning the cost of goods sold with the earliest acquisitions, ensuring that older items are not left to sit unused for too long. This approach is particularly useful in industries where products have expiration dates or are at risk of becoming obsolete.