What is FIFO & LIFO?
FIFO (which stands for First In, First Out) is a method of keeping count of the value of the inventory held by a company or organization, and states that the inventory that was added first to the stock will also be removed from the stock first.
It also means that whenever inventory is reported as sold, its cost will be considered equal to the cost of the oldest inventory that’s currently present in the same stock.
In regards to the profit and loss statement, the cost of inventory sold will be taken as the oldest inventory present in stock. On the balance sheet however, the cost of the inventory still in stock will be calculated as equal to the cost of the most recent inventory that was added to the stock.
LIFO (which stands for Last In, First Out) is similar to FIFO, except it implies that the inventory which was added last to the stock will be removed from the stock first. So the inventory will leave the stock in reverse of how it was added in the first place.
In other words, whenever the inventory is reported as sold, its cost will be taken equal to the cost of the latest inventory that was added to the stock.
This leads to the cost of inventory sold, as shown in the profit and loss statement, to be taken as equal to the cost of the oldest inventory that is currently present in the stock.
Why are they important?
At the end of every business’s fiscal year, there comes a time where auditors, business owners, managers, accountants, etc. want to begin taking inventory. The most convenient methods of valuing inventory, are by using FIFO and LIFO.
How is Inventory Valued?
Most companies make money by making products for sale or by purchasing the products from a wholesaler to re-sell, which both involve having a supply of unsold products or inventory. Although it hasn’t been sold yet, inventory still holds value because it is seen as a business asset. The end of each fiscal year means that the company must figure out the costs of all the products in inventory in order to figure out the Cost of Goods Sold (COGS).
What is Cost of Goods Sold (COGS)
The Cost of Goods Sold (or COGS) is a figure that represents the accumulated amount spent on all costs that were used to create a product or service that has already been sold. These costs are then divided into three separate categories: direct labor, materials, and overhead. For context, in a service related industry, the cost of goods sold is considered to be the labor, payroll taxes, and the cost of services. In regards to a retail or wholesale business, the cost of goods sold is most likely to be the merchandise that was purchased from the manufacturer.
Since the cost of goods sold is the price of acquiring or manufacturing the products that a company sells during a specific period of time, the only costs that are included in the formula are the ones that are directly related to the manufacturing of the products. This includes the costs of labor, materials, and manufacturing overhead.
Let’s look at this example to garner a better idea of the cost of goods sold, the cost of goods sold for a car manufacturer would include the costs of the parts that go into making the car plus the labor costs that were used to assemble the car together. You would completely exclude the cost of sending the cars to the dealerships, as well as the cost of the labor used to sell the car.
Another good example would be a housekeeping service. In this case, the costs associated with keeping the business running would be referred to costs of services rather than costs of goods. Although a cleaning service still has business expenses and has to spend money in order to offer their services, they don’t have an inventory of goods that they’re able to sell. In the eyes of the IRS, costs of services can’t be claimed as costs of goods, so the company would actually have no cost of goods.
That said, there are a number of service-based companies that also have physical products that are up for sale. Hotels and airlines are examples of service based companies that also offer products like drinks, food, etc. These items are still considered goods and can be claimed as goods on their income statements as well as for tax purposes. In this circumstance, the price of goods sold would include the direct cost of producing the good or the wholesale price of the goods that are resold.
These companies are also able to deduct costs of labor as long as the labor was involved in the good’s production, overhead, and shipping costs. The companies that are able to claim cost of goods sold, do it based on their gross receipts on Schedule C, lines 35 through 42. Which is only possible if the company correctly estimates its inventory at the start and end of each tax year. In order to get the most out of your labor and to ensure that you have more time to focus on organizing your inventory, make sure that you research how Deputy can help you put your employee schedules together. Click on the button below to start your trial and see Deputy in action for yourself.
Description of the Methods of Inventory Valuation
Companies are constantly having their inventory come in & out, so keeping up with the cost of inventory can get quite complicated. Fortunately, there are a number of accounting principles that help businesses in calculating their cost of inventory. While this post will be focusing on FIFO vs LIFO, we will also touch on two other methods that can be used to stay up to date on a store’s inventory.
- FIFO (First-In, First-Out): The FIFO method assumes that the first products that are brought to inventory are also sold first. For example, say there is an ice cream shop that made 200 scoops of ice cream on Wednesday at $1.00 each, then 200 more on Thursday at $1.50 each. FIFO determines that the COGS (cost of goods sold) is $1.00 per scoop because that was the cost of each of the ice cream scoops in the inventory. The scoops that cost $1.50 each would be allocated to ending inventory.
- LIFO (Last-In, Last-Out): The LIFO method assumes that the products that were brought last to inventory are sold first. In the ice cream shop example used above, the $1.50 price per scoop would be used as the COGS (cost of goods sold) while the leftover $1.00 scoops would be allocated to ending inventory.
- Specific Value: For certain products, their value has to be valued individually and will retain a very specific value that was specifically assigned to it. Some examples include jewelry, used cars, artwork, collectible items, etc. The price for these items are normally the cost to purchase them in the first place, so their profit can be easily determined.
- Average Cost: This method is pretty straightforward and uses math to find the average cost of the inventory sold. It involves adding up the cost of all of the items in the inventory and then dividing the total by the number of items. It is best suited for individually valued items.
FIFO vs LIFO: Which Should you Choose?
Now that you’re better familiarized with FIFO and LIFO, as well as their components and order of procedures, let’s address the pros and cons of both to determine whether or not they’d be a good fit for your organization.
Pros of FIFO:
- A company using the FIFO method is much less likely to be left with old and outdated inventory that can no longer be sold. After a certain amount of time has gone by and the leftover inventory isn’t bought or sold, the company has to write off Obsolete Inventory. Obsolete Inventory is defined as inventory that is at the end of its product life cycle and can no longer be sold, or at least, can’t be sold for a long period of time. Companies work to have as small amount of Obsolete Inventory as possible because it can end up being a large financial cost for the company. Because the idea of FIFO revolves around the oldest products in inventory being sold first, there is less of a chance of products outliving their product lifecycle.
- Inflation can make it difficult for many companies that are dealing with purchasing inventory at a price that is constantly fluctuating. By using FIFO, companies are able to offset the effects of inflation by selling off their inventory that was bought at a high price before the price rises. For example, say you run a warm cookie restaurant and purchase a large quantity of cookie dough for $6,000 in January. When March rolls around and it’s time to purchase the cookie dough again, it is now priced at $8,000 instead of $6,000. If the cookie restaurant was using FIFO, then they would have already sold the first bag of cookie dough before the price increased. So they would be able to sell their latest batch of cookie dough at the newest inflated price.
- It is crucial for many companies to keep up with their financial recordings by having a quick reference of the current market prices for the items in their inventory, which can be difficult when prices are constantly changing. By taking the older products from the inventory to be sold, the newest inventory is then leftover for financial recordings. This causes a company’s balance sheet to always display the most current market prices.
Cons of FIFO:
- One of the biggest drawbacks of FIFO is that you will have to offer your customers inconsistent pricing if you’re dealing with fluctuating market prices. Referring back to the cookie store example from above, if you have a regular customer that is used to purchasing cookies for $1.50 each, then you increase the price to $1.75, the customer can potentially be put off by the price increase and take their business elsewhere.
- Another disadvantage is that you may not always be able to keep up with market prices if they’re increasing or decreasing rapidly. If the prices of inventory suddenly double or triple, and your accountants are still using the prices from months or even years back, then your cost will end up being inaccurate.
Pros of LIFO:
- One of the biggest advantages of LIFO is actually a tax advantage. Whenever inflation occurs, LIFO will result in a higher cost of goods sold along with a lower balance on the remaining inventory. Since there is a higher cost of goods that are sold, this will result in a lower net income and a smaller tax liability.
- LIFO works by matching the most recent costs to the current revenue. The FIFO method works by matching old, dated costs to the current revenues in a market that is currently experiencing inflation. This creates Inventory Profit (the increase in the value of an item that was held in inventory for a certain period of time) which will understate the costs of goods sold and overstates the profits. LIFO works to reduce inventory profits by matching the most recent costs against revenues and reducing the understatement of COGS and the overstatement of profit. Which means that LIFO has the potential to improve the quality of earnings for those that use it.
Cons of LIFO:
- LIFO can make it difficult for a company to maintain their inventory system because it uses the most recent purchases as the COGS, which could lead to a group of old inventory that was never sold. Because the inventory costs never leave the system of accounting, LIFO requires a level of financial recording that is more complex than usual.
- If you’re planning on building a company that will one day expand internationally then LIFO wouldn’t be a good fit for you. That’s because there is a number of international accounting standards that don’t allow for a valuation of LIFO, two examples of which are the IFR and the UK GAAP.
The decision on using FIFO vs LIFO is ultimately up to the company and those in charge. That said, it should be stated that FIFO is the industry standard and the most common method of inventory valuation. If you’re planning on opening a business that will make use of inventory, then it’s suggested that you first go with FIFO and only consider LIFO if you notice any substantial benefits for your specific type of business.
No matter which of the methods you choose to go with, you need your business to be efficient in how it handles your employee scheduling as well as their time and attendance. Make sure to click on the button below to start your free trial of Deputy and see for yourself how it works to strengthen your business.
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