FIFO vs LIFO: Formula, calculation & examples

Under the LIFO method, assuming a period of rising prices, the most expensive items are sold. This means the value of inventory is minimized and the value of cost of goods sold is increased. This means taxable net income is lower under the LIFO method and the resulting tax liability is lower under the LIFO method. The FIFO method goes on the assumption that the older units in a company’s inventory have been sold first.

For retailers and wholesalers, the largest inventoriable cost is the purchase cost. We’ll calculate the cost of goods sold balance and ending inventory, starting with the FIFO method. The FIFO (“First-In, First-Out”) method means that the cost of a company’s oldest inventory is used in the COGS (Cost of Goods Sold) calculation. LIFO (“Last-In, First-Out”) means that the cost of a company’s most recent inventory is used instead.

Below are the Ending Inventory Valuations:

FIFO and LIFO inventory valuations differ because each method makes a different assumption about the units sold. To understand FIFO vs. LIFO flow of inventory, you need to visualize inventory items sitting on the shelf, each with a cost assigned to it. FIFO has advantages and disadvantages compared to other inventory methods.

Businesses would use the LIFO method to help them better match their current costs with their revenue. This is particularly useful in industries where there are frequent changes in the cost of inventory. This is achieved because the LIFO method assumes that the most recent inventory items are sold first. Assuming that prices are rising, this means that inventory levels are going to be highest as the most recent goods (often the most expensive) are being kept in inventory. This also means that the earliest goods (often the least expensive) are reported under the cost of goods sold. Because the expenses are usually lower under the FIFO method, net income is higher, resulting in a potentially higher tax liability.

FIFO vs. LIFO

The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period. One of its drawbacks is that it does not correspond to the normal physical flow of most inventories.

Finally, weighted average cost provides a clearer position of the costs of goods sold, as it takes into account all of the inventory units available for sale. This gives businesses a better representation of the costs of goods sold. Also, the weighted average cost method takes into consideration fluctuations in the cost of inventory.

LIFO vs. FIFO: Net Income Impact Examples

The store owner will put the older milk at the front of the shelf, with the hopes that the Monday shipment will sell first. The LIFO system is founded on the assumption that the latest items to be stored are the first items to be sold. It is a recommended technique for businesses dealing in products that are not perishable or ones that don’t face the risk of obsolescence. If your business has inventory, how you account for that product or raw materials stash can have a big effect on your business’s results. Since inventory costs have increased in recent times, LIFO shows higher COGS and lower net income – whereas COGS is lower under FIFO, so net income is higher. In this case, the store sells 100 of the $50 units and 20 of the $54 units, and the cost of goods sold totals $6,080.

As a result, the 2021 profit on shirt sales will be different, along with the income tax liability. Again, these are short-term differences that are eliminated when all of the shirts are sold. FIFO assumes that cheaper items are sold first, generating a higher profit than LIFO.

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As a result, LIFO doesn’t provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today’s prices. Also, LIFO is not realistic for many companies https://turbo-tax.org/federal-tax-laws/ because they would not leave their older inventory sitting idle in stock while using the most recently acquired inventory. FIFO is mostly recommended for businesses that deal in perishable products.

• In sum, using the LIFO method generally results in a higher cost of goods sold and smaller net profit on the balance sheet.
• The average cost method produces results that fall somewhere between FIFO and LIFO.
• Using FIFO means the cost of a sale will be higher because the more expensive items in inventory are being sold off first.
• Also, through matching lower cost inventory with revenue, the FIFO method can minimize a business’ tax liability when prices are declining.
• Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory.