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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 methodThe 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 :
Disadvantages Of Using LIFO Vs FIFO Method :
Example of LIFO methodUsing 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 PeriodicUnits 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 AccountingDate 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 :
Example of FIFO methodBike 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 :
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.
Top 12 FREE Software For Small BusinessesWe've curated a list of best free software that every business owner must use. Get this eBook on your email. Which inventory method would give the highest net profit?During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.
Which inventory method provides the highest profit and why?The FIFO method gives you more accurate information as it assumes the older inventory items are less costly and are the ones sold first. Also, the FIFO method provides you with the highest profit as the first items in stock are often the cheapest.
Is LIFO or FIFO better when prices are rising?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.
Which inventory method usually gives higher net income when prices are rising?“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.
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