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FIFO & LIFO

24/06/2021

Shared Knowledge = Shared Values

Data Collected By: Hamed Ali
 June 24, 2021 [FIFO & LIFO]

Article Subject FIFO & LIFO.

Data collected by Hamed Ali Mohamed, Master in food science & bio-technology
E-mail [email protected] Address Eastern Provence, KSA

Release Date 24/06/2021 Doc. Ref (FU)/KSA – 2021 – 06 -39

What Is the Difference Between FIFO and LIFO?

The method a company uses to assess their inventory costs will affect their profits. The
amount of profits a company declares will directly affect their income taxes.
Inventory refers to purchased goods with the intention of reselling, or produced goods
(including labor, material & manufacturing overhead costs).
Which Method Is Better FIFO or LIFO?
FIFO is considered to be the more transparent and trusted method of calculating cost of goods
sold, over LIFO. Here’s why.
By its very nature, the “First-In, First-Out” method is easier to understand and implement.
Most businesses offload oldest products first anyway – since older inventory might become
obsolete and lose value. As such, FIFO is just following that natural flow of inventory,
meaning less chance of mistakes when it comes to bookkeeping.
LIFO allows a business to use the most recent inventory costs first. These costs are typically
higher than what it cost previously to produce or acquire older inventory. As such, profits are
lower. Although this may mean less tax for a company to pay under LIFO, it also means
stated profits with FIFO are much more accurate because older inventory reflects the actual
costs of that inventory. If profits are naturally high under FIFO, then the company becomes
that much more attractive to investors.
The problem with a company switching to the LIFO method is that the older inventory may
stay on the books forever, and that older inventory (if not perishable or obsolete) will not
reflect current market values. It will be understated.
How Do You Calculate FIFO and LIFO?
To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your
oldest inventory. Multiply that cost by the amount of inventory sold.
To calculate COGS (Cost of Goods Sold) using the LIFO method, determine the cost of your
most recent inventory. Multiply that cost by the amount of inventory sold.
Prices paid by a company for its inventory often fluctuate. These fluctuating costs must be
taken into account regardless of which method a business uses.

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Lastly, the product needs to have been sold to be used in the equation. A company cannot
apply unsold inventory to the cost of goods calculation.
FIFO and LIFO Examples
We are going to use one company as an example to demonstrate calculating the cost of goods
sold with both FIFO and LIFO methods.
Ted’s Televisions is a business in New York City. Ted has been in operation now for a year.
This is what his inventory costs looks like:
Month Amount Price Paid
January 100 Units $800.00
February 100 Units $800.00
March 100 Units $825.00
April 100 Units $825.00
May 100 Units $825.00
June 100 Units $850.00
July 100 Units $850.00
August 150 Units $875.00
September 150 Units $875.00
October 150 Units $900.00
November 150 Units $900.00
December 150 Units $900.00
1450 units acquired.
Units = Televisions.
As you can see, the unit price of televisions steadily increased. Assuming Ted kept his sales
prices the same (which he did, in order to stay competitive), this means there was less profit
for Ted’s Televisions by the end of the year.
For the year, the number of televisions sold was 1100.
Let’s calculate cost of goods sold using the:

FIFO METHOD
Going by the FIFO method, Ted needs to use the older costs of acquiring his inventory and
work ahead from there.
So Ted’s COGS calculation is as follows:

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200 units x $800 = $160,000

300 units x $825 = $247,500
200 units x $850 = $170,000
300 units x $875 = $262,500
100 units x $900 = $90,000
Ted’s cost of goods sold is $930,000.
LIFO method
Going by the LIFO method, Ted needs to go by his most recent inventory costs first and work
backwards from there.
450 units x 900 = $405,000
300 units x 875 = $262,500
200 units x 850 = $170,000
150 units x $825 = $125,750
Ted’s cost of goods sold is $961,250.
You can see how for Ted, the LIFO method may be more attractive than FIFO. This is
because the LIFO number reflects a higher inventory cost, meaning less profit and less taxes
to pay at tax time.
The LIFO reserve in this example is $31,250. The LIFO reserve is the amount by which a
company’s taxable income has been deferred, as compared to the FIFO method.
The remaining unsold 350 televisions will be accounted for in “inventory”.

LIFO or FIFO: It Really Does Matter

The difference between $8,000, $15,000 and $11,250 is considerable. In a complete
fundamental analysis of ABC Company, we could use these inventory figures to calculate
other metrics—factors that expose a company's current financial health, and which enable us
to make projections about its future, for example. So, which inventory figure a company starts
with when valuing its inventory really does matter. And companies are required by law to
state which accounting method they used in their published financials.
Although the ABC Company example above is fairly straightforward, the subject of inventory
and whether to use LIFO, FIFO, or average cost can be complex. 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. Managing inventory can help a company control and
forecast its earnings. Conversely, not knowing how to use inventory to its advantage, can
prevent a company from operating efficiently. For investors, inventory can be one of the most

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important items to analyze because it can provide insight into what's happening with a
company's core business.
Last in/first out (LIFO) and first in/first out (FIFO) are the two most common types of
inventory valuation methods used. Both LIFO and FIFO are GAAP-approved inventory
methods, but if you decide to use LIFO, you’ll need to complete a special application with the
IRS for approval.
If you do receive permission to use LIFO in your business, you will not be able to return to
FIFO without permission from the IRS.
If you do business globally, you’ll need to stick with FIFO or another approved inventory
valuation method since the international accounting standards body (IFRS) prohibits the use
of LIFO.
The main difference between LIFO and FIFO is based on the assertion that the most recent
inventory purchased is usually the most expensive. If that assertion is accurate, using LIFO
will result in a higher cost of goods sold and less profit, which also directly affects the
amount of taxes you’ll have to pay.
What is LIFO?
The LIFO method assumes the last items placed in inventory are the first sold.
For instance, if you purchase 100 units on May 15 for $500 and 100 units on May 27 for
$750, and you sell 150 units on May 31, all of the more expensive units that were purchased
on May 27 would be sold first, along with 50 of the less expensive units that were purchased
on May 15.
What is FIFO?
The FIFO method assumes the oldest items in inventory are sold first. Using the same
example as above, with 100 units purchased on May 15 for $500 and 100 units purchased on
May 27 for $750, when you sold 150 units on May 31, you would sell all of the May 15 units
along with 50 of the May 27 units.
LIFO vs. FIFO: What's the difference?
LIFO and FIFO are inventory valuation methods that work on different premises. While the
names are self-explanatory, remember that the method you choose will directly affect your
key financial statements such as your balance sheet, income statement, and statement of cash
flow.
As mentioned earlier, LIFO will increase inventory valuation and lower net income, while
FIFO will lower inventory valuation and increase income, based on the assumption that later
inventory purchases are more expensive.

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However, if the units had been purchased on May 15 and May 27 for the same amount, there
would be no impact on financial statements.
Use cases for LIFO
Most companies prefer FIFO to LIFO because there is no valid reason for using recent
inventory first, while leaving older inventory to become outdated. This is particularly true if
you’re selling perishable items or items that can quickly become obsolete.
While in most cases, FIFO is the better option, LIFO can be used for the following reasons:
• Better matching of product cost with revenue: By selling newer inventory products first,
the cost will be better matched with revenue. If older, less expensive inventory is sold first,
the profit level of the business will be artificially inflated.

• Lower taxes: Using the more expensive products first will lower net income and, in turn,
lower profits, which means your business will have a lower taxable income income.

Use cases for FIFO

FIFO is the preferred inventory valuation method for most businesses for a variety of reasons.
If your products are perishable, have an expiration date, or quickly become obsolete, FIFO is
the only method you should use. Here are some additional reasons you may choose to use
FIFO:
• Easier to manage: FIFO is easily understood, and it’s the accepted method of the IRS as well
as international businesses.

• More accurate financial statements: Using FIFO makes it much harder to manipulate
company finances.

• You have international locations: If you have international locations, the IRS requires you
to use FIFO for inventory valuation.

• Product costs are dropping: If your product costs have dropped, it’s beneficial to use FIFO,
which will increase your cost of goods sold while lowering net income, allowing you to
reduce your taxes.

• Easier tracking: FIFO is tracked based on the natural flow of inventory, which means older
products will be sold first. This eliminates the possibility of older and possibly obsolete
inventory that cannot be sold remaining on the books.

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Example of LIFO
Using the following example, we’ll be able to see how LIFO and FIFO affect the cost of
goods sold and net income.
Donna’s Doors started the month of May with $20,000 in inventory. That inventory includes
200 doors that Donna purchased for $100 each. In May, Donna purchased 125 more doors at
varying prices:
DATE UNITS PURCHASED UNIT COST INVENTORY VALUE
5-05-2020 50 doors $110 $5,500
5-15-2020 50 doors $120 $6,000
5-27-2020 25 doors $125 $3,125
On May 30, a customer purchased 150 doors at a cost of $250 per door. Here’s how the
inventory is valued using LIFO:
TRANSACTION LIFO
Sales (150 doors purchased at $250 per door) $ 37,500
Beginning inventory $ 20,000
Additional purchases $ 14,625
Ending inventory $ 17,500
Cost of goods sold $ 17,125
Net income $ 20,375
Using the LIFO valuation method, the cost of goods sold reflects the value of the inventory
that was included in the latest purchase. A total of 150 doors were sold, using inventory as
follows:
25 doors @$125 = $3,125
50 doors @$120 = $6,000
50 doors @$110 = $5,500
25 doors @$100 = $2,500
Using LIFO, the total cost of goods sold is $17,125.

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 June 24, 2021 [FIFO & LIFO]

Example of FIFO
Now, using the same scenario as above, we’ll calculate the cost of goods sold and net income
using FIFO:
TRANSACTION LIFO
Sales (150 doors purchased at $250 per door) $ 37,500
Beginning inventory $ 20,000
Additional purchases $ 14,625
Ending inventory $ 19,625
Cost of goods sold $ 15,000
Net income $ 22,500
Using FIFO, your cost of goods sold reflects the cost of the oldest inventory. The inventory
breakdown is simple:
150 doors @$100 = $15,000
Because all 150 doors came from the oldest inventory that was already in stock as of May 1,
it isn’t necessary to include any of the recent purchases in your cost of goods sold calculation.
Notice by using the older, less expensive inventory first, the ending inventory value has
increased, as has your net income. If inventory costs had remained the same, the cost of goods
sold and, subsequently, your net income would have also remained the same.
LIFO vs. FIFO really does matter
If you sell or plan to sell products, proper inventory management is a necessity.
Deciding whether to use LIFO or FIFO can be complicated, so be sure to consider both
options carefully before making a decision, since the inventory valuation method you choose
also will also have a significant impact on your financial statements.
You also need to remember that you need special permission from the IRS in order to use the
LIFO method, and if you do business internationally, you cannot use LIFO at all.
References: -
- www.educba.com .
- www.wallstreetmojo.com.
- www.Investopedia.com

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