admin February 14, 2022 Finance, strategy

LIFO and FIFO

LIFO and FIFO are methods employed in valuing the cost of all goods sold and the final ending inventory. FIFO, an acronym for First-in First-out, implies that first goods added to the list would assume to be the first goods to be removed or sold. LIFO on the other hand, an acronym for Last-in First-out, implies that products added to the inventory last would be the first to be removed or sold. Investors and business owners need to understand these methods as they happen to form a critical component of a company’s balance sheet.

Difference between FIFO and LIFO

In this section, we would be discussing the main differences between LIFO and FIFO inventory valuation method.

Stock in hand implies the oldest stock under LIFO, while Stock in hand under FIFO represents the newest goods that just arrived or produced.
The price of goods sold reflects the current market price under LIFO, while unsold goods reflect market price under the FIFO method.
Under various Financial Reporting Standards, FIFO is the only permissible method used, while the LIFO method is not allowed.
LIFO is known to exhibit real profit whenever there is inflation in the economy. This automatically helps in saving tax, while the scenario is the opposite in the case of FIFO.
Lastly, FIFO maintains a smaller number of records while LIFO requires more detailed record keeping.

Which method is Better FIFO or LIFO?

The choice of better method depends on the kind of goods that is in a business inventory. LIFO method should be used for auto dealers, supermarket, steel shop, electrical supply, hardware and some other building products, etc. However, in a case of small businesses or businesses whose products are perishable goods like vegetables, fruits, goods meant for exportation, and some other goods with a short expiry date, it would be best to engage in the FIFO method.

FIFO and LIFO Examples with the Calculations

Taking a look at the recent purchase of the company that has ordered for some unit of mobiles: 1^st week: 100units at $4 each = $400 2^nd week: 100 units at $5 = $500 3^rd week: 100 units at $7 = $700 Sum of all purchased inventory = $(400+500+700) = $1600 Beginning inventory: 100 units at $3 = $300 Consumption: 300 units were used up Sales: 300 pair of sates sold at $10 each =$3,000 Therefore, ending inventory value goes thus; LIFO: Last inventory are sold first, so oldest unit is $3 Ending inventory = 3 * 100 = $300 FIFO: oldest are sold, newest are remaining Ending inventory = 100 * 7 = $700 COGS calculation COGS= beginning inventory + inventory purchase – ending inventory LIFO COGS = 300 + 1600 – 300 = $1600 FIFO COGS= 300 +1600 – 700 = $1200 LIFO and FIFO effect on Gross Profit Margin Gross Profit = Total sales- COGS LIFO Gross Profit = 3,000-1,600= $1,400 FIFO Gross Profit = 3,000-1,200=$1,800 The above calculation shows the effect of the two methods on Gross Profit in the period of rising prices and as it is in the computation, LIFO gives a lower Gross Profit as compared to FIFO, which means the company would record lesser profit and therefore pay smaller tax. LIFO is accepted under GAAP (the U.S Generally Accepted Accounting Principles) while it not allowed under the International Financial Reporting Standards (IFRS).

Frequently Asked Questions

Q1. What do FIFO and LIFO mean?

FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are inventory valuation methods used to determine the cost of goods sold and the value of remaining inventory. FIFO assumes the oldest inventory items are sold first, while LIFO assumes the most recently purchased items are sold first.

Q2. What is the main difference between FIFO and LIFO?

The key difference lies in the order in which inventory costs are assigned. Under FIFO, older inventory costs are matched to sales, leaving newer costs in ending inventory. Under LIFO, newer inventory costs are matched to sales, leaving older costs in ending inventory.

Q3. How do FIFO and LIFO affect profitability?

During periods of rising prices, FIFO generally results in lower cost of goods sold and higher reported profits because older, lower-cost inventory is recognized first. LIFO typically results in higher cost of goods sold and lower reported profits because newer, higher-cost inventory is recognized first.

Q4. Why do businesses use inventory valuation methods like FIFO and LIFO?

Inventory valuation methods help businesses accurately calculate inventory value, cost of goods sold, taxable income, and profitability. The selected method can significantly influence financial reporting, performance analysis, and business decision-making.

Q5. Is LIFO allowed under all accounting standards?

No. While LIFO is permitted under certain accounting frameworks such as U.S. GAAP, it is generally not permitted under International Financial Reporting Standards (IFRS). FIFO is widely accepted under both major accounting frameworks.