FIFO vs. LIFO: Understanding inventory valuation methods

In retail, manufacturing and wholesale sales, solid profits result from closely managed inventory. 

FIFO and LIFO are the two most common ways businesses manage their inventory, influencing how they calculate cost of goods sold (COGS), inventory value, profits, and more. LIFO, short for last-in-first-out, and FIFO, short for first-in-first-out, are two inventory valuation methods that yield different net profits and inventory values for tax purposes.

Here, we’ll discuss inventory valuation, accounting principles, and how to decide between LIFO vs. FIFO methods based on your business.

What is FIFO?

FIFO stands for first-in-first-out. It’s a method of inventory management and valuation in which goods produced or acquired first are sold, used, or disposed of first. In other words, goods are sold in the order they were received.

For reporting purposes, FIFO assumes that assets with the oldest costs are included in the income statement’s COGS and newer goods are considered inventory. So, if you sell a product using FIFO, the cost of goods sold is the value of the older goods. FIFO is one of the most popular inventory accounting methods.

Using the FIFO method has some significant advantages:

• It’s more realistic because most businesses ship older stock first to avoid depreciation of value or spoilage.
• FIFO increases the value of your purchased inventory and company net worth in times of inflation. As a result, you apply a higher asset value.
• Your operational reports are always accurate. As you are selling the oldest items first, your balance sheet will always show the actual cost price of the inventory.

FIFO example

In the FIFO method, the initial purchasing cost is subtracted from its selling price to calculate the reported profit. Let’s understand how FIFO is used to calculate the cost of goods sold with an example below.

What is LIFO?

LIFO stands for last-in-first-out. It’s a method of inventory management and valuation in which goods produced or acquired most recently are recorded as sold first. In other words, the cost of the newest products is counted in the COGS, whereas the price of older goods is counted in inventory.

Some accountants in the U.S. advise using the LIFO method for your inventory accounting when you have stock with rising costs. But if prices are only rising due to inflation, LIFO inventory valuation might overinflate calculated profit.

Using LIFO as a preferred method for such scenarios helps match the latest cost of inventory with the sales revenue of the current period. This can be a more straightforward approach for initial inventory valuation as well as for tax filing purposes.

Unlike FIFO, LIFO has some disadvantages:

• LIFO brings taxable income down when your cost price rises, the LIFO method will yield lower reported profits on your taxes.
• Not all countries allow a LIFO valuation if you plan to expand your business in the near future.
• LIFO is not realistic for companies that sell perishable goods. Leaving the oldest inventory sitting idle could risk spoilage, leading to losses.

Example of LIFO

In the LIFO method, the most recent purchasing cost is subtracted from its selling price to calculate the reported profit. Using the LIFO method for inventory valuation and accounting lowers your return profit. 

The same example used earlier can be used to show the LIFO method for calculating the cost of goods sold.

Differences between FIFO and LIFO

FIFO or LIFO are the methods companies use to classify inventory and calculate profit. The amount of profit a company generates affects their income taxes and is a key component of measuring overall performance. Each inventory method yields different profits, so it’s important to know which makes the most sense for your business.

Which method is better?

In general, FIFO is a safer bet than LIFO because there aren’t restrictions from the GAAP or IFRS. However, your business may benefit from LIFO inventory if it’s allowed. To know which method is best suited for your business, you need to look at the way your inventory costs are changing.

• If your inventory cost is increasing or is likely to increase in the near future, LIFO can be better. Because the cost of goods is higher, you will benefit from the lower taxes.
• If your inventory cost could be decreasing in the near future, FIFO is the best option.
• If your preference is to accurately assess your inventory cost, FIFO is the better option. This is because FIFO operates on the assumption that the older and less costly items are usually sold first.

What is inventory, and how is it valued?

Inventory is the material and goods that make up a selling product for a company. Inventory management is essential for businesses to track their spending and value for tax and internal purposes. Generally speaking, inventory can be classified into three stages:

• Raw materials
• Items in production
• Goods ready for sale

Based on your business needs, internal accounting staff may need to assign value to inventory and classify it as a company asset since inventory can turn into cash in the near future. In order to accurately value your company, all your company’s assets may need to be assessed.

At the beginning and end of the fiscal year, you should perform an inventory valuation. For valuation purposes, you must:

• Apply Generally Accepted Accounting Principles (GAAP)
• Clearly reflect your income
• Maintain consistency from year to year

GAAP refers to a standard set of accounting principles that have been issued by the Financial Accounting Standards Board (FASB). GAAP suggests that businesses use one of two different inventory accounting methods: FIFO or LIFO. However, the International Financial Reporting Standards (IFRS) forbid LIFO. 

When your company needs to determine income and expenses for accounting purposes, there are two methods:

• Cash accounting: Records transactions when invoices or bills are paid
• Accrual accounting: Records transactions when invoices or bills are created

According to the Internal Revenue Service (IRS), if your business is holding inventory, you are required to use the accrual method of accounting. This is why it’s essential to follow inventory control best practices.

GAAP/IFRS regulations for FIFO and LIFO

Generally Accepted Accounting Principles set the standards for accounting procedures in the United States. Under GAAP, both FIFO and LIFO are allowed.

However, IFRS issued by the International Accounting Standards Body (IASB) does not permit use of the LIFO method.

Outside of the U.S., most other countries follow the rules set by the IASB. This is why U.S.-based companies using the LIFO method for local financial statements use the FIFO method for overseas operations.

If you ever decide that it would be ideal for your business to switch from the LIFO method to the FIFO method, you need to file Form 970 with the IRS. You’re allowed to go back to LIFO only if the IRS gives specific permission. 

Simplify inventory management with Cin7

It’s important to know how the LIFO vs. FIFO methods work to choose the best inventory management techniques for your business and maximize tax benefits. Both methods have their pros and cons, so you should choose the method that best suits your business. If you operate internationally, FIFO is the best option because LIFO doesn’t meet compliance requirements in most countries.

Cin7 was built with modern businesses in mind and only supports the FIFO method. Our inventory and order management software supports better accounting and offers a cloud-based solution that integrates all your sales channels into a single platform. Cin7 products provide advanced automation processes to create seamless transactions centered around a positive customer experience.

Ditch the spreadsheets and stop manual data entry. Start a free trial to explore how to reach new markets with Cin7’s inventory and order management system.

FAQ

Looking for more information on LIFO and FIFO methods? Read our expert responses to your top questions below.

Which is better, LIFO or FIFO?

In general, FIFO has no restrictions from GAAP or IFRS and is a more accurate way to report inventory. However, LIFO can be useful if inventory costs are increasing and you operate in the U.S.

Why would a company use FIFO?

FIFO is the most popular inventory method because it’s unrestricted for U.S.- or international-based companies and it increases the value of purchased inventory.

Is LIFO or FIFO better for taxes?

LIFO might be better for taxes if your product’s inventory value changes frequently. Otherwise, FIFO is typically more accurate.