Q 381. LIFO and FIFO are two commonly used methods for inventory management. Explain the differences between the two methods and provide examples where these are used.

 

 

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FIFO and LIFO are methods used in the cost of goods sold calculations in financial accounting. FIFO stands for First in First out and it assumes that the oldest products / materials / items in a company’s inventory have been sold first and goes by those production costs. However contrary to it, The LIFO stands for Last In First Out and this method assumes that the most recent products in a company’s inventory have been sold first and uses costs of recent products instead. These methods are used to manage assumptions of costs related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

Below diagram clearly explains the difference between the two methods :

If we want to understand LIFO and FIFO concept in Day to Day activities, Imagine a Railway Ticket counter for FIFO : (Person who gets in queue 1^st is the 1^st to get out normally  )

However imagine a Ticket Checker following the concept of LIFO i.e. The Person who got into the train last shall be checked for ticket 1^st  (As probability of not having ticket is high).

 

Lets understand the difference between the two methods and benefits of each one of these with Financial Aspects now !

FIFO (First In First Out) :

In FIFO method, oldest inventory items are recorded as sold first (but this does not necessarily mean that the exact oldest physical object was tracked and sold). Here, the cost associated with the inventory that was purchased first is the cost expensed first.A company might use the LIFO method for accounting purposes, even if it uses FIFO (First In First Out) method for inventory management purposes (i.e., for the actual storage, shelving, and sale of its merchandise). E.g. If a company that sells many perishable goods, such as a supermarket chain, is likely to follow the FIFO method when managing inventory so that goods with earlier expiry dates are sold first and goods with later expiry dates thereafter. However, this does not mean that same company can not use LIFO method for accounting for its merchandise management.

 

While using the FIFO method, the cost of inventory reported on the balance sheet represents the cost of the inventory which was purchased most recently. FIFO most closely represents the flow of inventory, as businesses are likely to sell the oldest inventory first.

 

Lets see this with example as below where say company XYZ has following inventory in had of 600 units those were purchased at different point of time with cost as mentioned :

 

 

Number of Units	Cost (INR)
100 units (1st)	100 INR
200 units (2nd)	150 INR
300 units (3rd)	200 INR

 

Now say company sells 550 units and then the company would expense the cost of 1^st 100 units at 100 INR (Lot 1) and next 200 units at 150 INR (Lot 2) and remaining 250 units at 200 INR (Lot 3) using the FIFO method. So here the total cost of Sales will be (100*100) + (200*150) + (250*200) = 10000 + 30000 + 50000 = 90000 INR.

 

And cost of remaining inventory i.e. 50 units (600 total – 550 sold) will be calculated as per cost / unit for the latest lot i.e. 50*200 = 10000 INR and hence the balance sheet will show this amount as Inventory Value. As per FIFO method, company will have low cost of goods sold and high inventory value and therefore profits here will be shown as high (Profit = Sales – Cost of Goods Sold) due to lower cost of Goods sold and hence company will be liable to pay higher taxes.

 

LIFO :  (Last In First Out)

In this method, most recently produced items are recorded as sold first. From 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes at the times of inflation, but International Financial Reporting Standards (IFRS) banned LIFO method and hence more companies returned to FIFO.

 

LIFO method is used only in United States and it is governed by the Generally Accepted Accounting Principles (GAAP). Section 472 of the Internal Revenue Code throws the light on how to use the LIFO method.

In the example above, company XYZ using LIFO would expense the cost associated with the first 300 units at 200 INR, next 200 units at 150 INR, and the remaining 50 units at 100 INR. Under LIFO, the total cost of sales would be = (300*200) + (200*150) + (100*50) = 95000 and the ending inventory would be calculated as follows :

Remaining 50 units = 50*100 = 5000 INR, so here the balance sheet will show 5000 INR as Inventory value in contrary to 10000 INR using FIFO and profit here will be shown as low due to higher cost of Goods Sold and hence the company would be paying the less taxes here than using the FIFO method.

 

The difference in value of inventory calculated using the LIFO and FIFO methods is called as LIFO reserve which is 10000 INR – 5000 INR = 5000 INR in this example and This reserve is the amount by which company’s taxable income has been deferred by using the LIFO method.As a rule in the United States, publicly traded entities which use LIFO for taxation purposes must also use LIFO for financial reporting purposes as well and such companies should report LIFO reserve to its shareholders.

 

Examples of the Companies that use LIFO method : (US Only)

General Electric, Walmart, DOW, Caterpillar and ExxonMobil etc.

Examples of companies that uses FIFO method :

Sectors Prefer to use LIFO Methods : Where there is high difference in prices of goods / materials purchased) i.e.

Petroleum, Pharmaceuticals , Retail etc.

Sectors use FIFO Method : Where the Shelf Life is quite less and not much variation in Prices on daily basis. E.g. Dairy Products, Fruits and Vegetable Vendors, Courier Services etc.

 

So in nutshell, Companies use LIFO to take tax benefits and to trade off the inflation effects on profits in highly price volatile industries. However, this is used in US only as its banned everwhere else. FIFO is worldwide accepted and simple and clear method of accounting and largely companies use this only.

 

FIFO & LIFO are methods used in cost of goods sold calculation. Or they can also be said as methods of managing inventory. Before we get further into understanding FIFO & LIFO, let understand what is Inventory 

 

Inventory :

It refers to a company's goods in 3 stages of production

1. Goods that are in the form of Raw Materials

2. Goods that are in Production

3. Goods that are finished & ready to Sale 

Elaborately, the goods that a company has from the beginning added with materials that are purchased to prepare more goods & Subtracted with the goods that the company sold ( COGS: Cost of Goods Sold) , The Result which remains is called Inventory.

 Inventory Accounting values goods at each production stage and classifies them as Company Assets ( As Inventory can be sold & turned into cash in future ) Therefore Assets of the company need to be properly valued

The formula to calculated Inventory :

EI ( Ending Inventory ) = Beginning Inventory ( BI) + Net Purchase - Cost Of Goods Sold ( COGS)

This accounting method has a direct impact on Key financials, Balance sheet, income statement& statement of cash flows, Therefore, the GAAP( Generally accepted accounting principles) allow Businesses to use one of the accounting methods - LIFO, FIFO & Average Cost.

It can also be said that FIFO & LIFO accounting are the methods that are used in managing inventory & financial matter that involve the amount of money a company has to have with the inventory of Raw Material, Parts, Produced Goods, components OR stock

LIFO & FIFO are used to manage assumptions of cost to inventory, repurchase of stocks and other various accounting purpose .The equation followed will help determining inventory costing methods

 

FIFO : FIFO stands for First In First Out which means the oldest repository is tracked to have sold First . It can also be said that the cost associated with the inventory that was purchased initially or at the beginning is the cost expensed first. The cost of inventory in FIFO that gets reported in Balance sheer represents the cost of the inventory most recently purchased. It closes resembles the flow on Inventory that reaches first. With FIFO the cost of inventory reported represents the cost of the inventory most recently purchased 

Example: A supermarket chain would most likely follow a FIFI method of managing inventory to ensure goods with earlier expiration are sold before goods with later expiration dates

 

Lets imagine a company "XYZ" had the below mentioned inventory in stock 

Number of units Cost

100 units - $100,  150 units-  $150,  50 Units - $160

If XYZ company sells 220 units in July, the cost of expense would be 

First 100 units at $ 100 and remaining 120 units at $ 150. Therefore under FIFO the total cost of sale for July would be

$ 28,000 . The ending stock/ inventory would be  (30 * $150 ) + (50 *$160) = $ 12500

 

LIFO :  Last in Last out  method which assumes last or recent unit that arrive in inventory is sold first.The LIFO method assumes that the most recent products in a company's inventory is sold first and uses those cost instead

 

If the same XYZ company is considered here the 220 units sold incurs the following cost 

(50 Units * $160 ) + (150 Units * $150 ) + (Remaining 20 Units * $100) = $ 32500 

The ending stock/ Inventory would be  here 80*$100 = $ 8000 . The Balance sheet here would show $ 8000 under LIFO 

 

The difference between the cost of an inventory calculated between LIFO & FIFO is called LIFO reserve. This reserve is the amount by which an entity's taxable income has been deferred by LIFO

 

LIFO Vs FIFO 

LIFO uses the most recently acquired inventory to value COGS . The left over inventory is extremely old or obsolete. As a Result LIFO does not give an accurate or Up to date value as the valuation is much lower than current price. Also it seems to be unrealistic because companies would not leave their older inventory idle in stock while using recently acquired inventory . LIFO is not a practical method in companies which sells perishable goods which does not reflect the logical production process of using Oldest inventory first

Whereas, FIFO can be a good indicator of the value for finishing inventory because the old items have been used up while recently acquired items are basis the current Market price.For majority of the companies, it is the most logical choice as usage of oldest inventory first in production of goods signifies the valuation of COGS that reflects in their production schedule . For LIFO the profits are reduced as compared to FIFO .

To sumarize   

LIFO	FIFO
Increased COGS	Lower COGS
Reduced Profits	Higher profits
Lower tax Liability	Higher Tax liability

 

Therefore FIFO seems to be a more logical approach of managing inventory as compared to LIFO

 

LIFO AND FIFO FOR INVENTORY MANAGEMENT

FIFO and LIFO are the methods used in Inventory Management. FIFO stands for “First-In, First-Out” method and it is assumed that the oldest products in a company’s inventory are sold first. The LIFO stands for “Last-In, First-Out” method and it is assumed that the most recent produced products in a company’s inventory are sold first.

What’s the Difference in Methods? 

The first difference is that they are opposite in the way the flow of inventory takes place, and how they’re carried out. The difference depends on the kind of Business we run and accordingly the method will work best for us. 

For example, if we sell computers/ laptops, then the FIFO method would work best, as we don’t want the old stock to sit there and fall into obsolescence. While if we sell fresh cakes, the LIFO method would work better. As we want that fresh produce to go to market before it goes bad. 

Otherwise, depending on our product, we can figure out if the FIFO or LIFO method is best for us. Choosing the right method will help us to maximize profit. 

As the methods go off inventory totals, it is always assumed that stock is being sold as intended orders. This helps us in calculating the cost of goods sold (COGS). 

Which Method Is Better FIFO or LIFO?

FIFO is considered to be the best, transparent and most trusted method of COGS, over LIFO. The reasons are:-

FIFO method is very easy to understand and implement. In real environment, Businesses often try to offload oldest products first since older inventory might become obsolete as time passes and lose value. FIFO is just following the normal flow of inventory, it means we have less chance of mistakes when it comes to Accounting.

LIFO method allows a business to use the most recent inventory costs first. These costs are higher than what it had cost previously to produce goods. As such, profits are always lower. This means company will have to pay lesser Tax under LIFO, it can also be thought of that stated profits with FIFO are much more accurate because older inventory reflects the actual costs of that inventory.

The problem which is most commonly seen with a company switching to the LIFO method is that the older inventory will stay on the books forever, and will not reflect current market values if older inventory is not perishable or obsolete. It will be understated.

Lastly, with LIFO method, it is very easy to manipulate financial statements.

It is always considered a best practice to go with FIFO.

How Do we Calculate FIFO and LIFO?

To calculate COGS (Cost of Goods Sold) using the FIFO method, we determine the cost of our oldest inventory and then multiply that cost by the amount of inventory sold.

To calculate COGS (Cost of Goods Sold) using the LIFO method, we determine the cost of our most recent inventory and then multiply that cost by the amount of inventory sold.

The prices that a Company pays for its inventory often fluctuate and these fluctuating costs must be taken into account regardless of which method a business uses.

FIFO and LIFO Examples

To better understand this Concepts, we will have say Company ABC which has Business of Selling TV’s in Mumbai, let us use this as an example to demonstrate calculating the COGS with both FIFO and LIFO methods.

This is what the Company’s inventory costs looks like:

 

Month	No. of Units	Amount per Unit (₹)
January	10	20000
February	10	20000
March	10	20500
April	10	20500
May	10	20500
June	10	21000
July	10	21000
August	15	21500
September	15	21500
October	15	22000
November	15	22000
December	15	22000
Total	145

As we can see from the table above, the unit price of televisions steadily increased. Assuming the Company kept his sales prices the same (which they did, in order to stay competitive), this means there was less profit for the Company by the end of the year.

For the year, the number of TV’s sold was 110.

Let’s calculate COGS using the:

FIFO method

Going by the FIFO method, ABC needs to use the older costs of acquiring his inventory.

So ABC COGS calculation is as follows:

No. of Units	Cost per Unit (₹)	Price Paid (₹)
20	20000	400000
30	20500	615000
20	21000	420000
30	21500	645000
10	22000	220000

ABC cost of goods sold (COGS) is ₹ 2300000

LIFO method

Going by the LIFO method, the company ABC needs to go by there most recent inventory costs first and work backwards from there.

No. of Units	Cost per Unit (₹)	Price Paid (₹)
45	22000	990000
30	21500	645000
20	21000	420000
15	20500	307500

ABC cost of goods sold (COGS) is ₹ 2362500

As we can clearly see from above examples, the LIFO method looks more attractive than FIFO. This is because the LIFO number reflects a higher inventory cost, means less profit and less taxes to pay.

The LIFO reserve in this example is ₹62,500. This reserve is the amount by which a company’s taxable income is deferred, as compared to the FIFO method.

The remaining unsold 35 TV’s will be accounted for in “inventory”.

LIFO, is a form of inventory administration wherein the product or material received last, is disbursed first and thus the stock in hand, consist of newest batch.

On the other hand, FIFO is another method of inventory administration, in which the product or material received first is disbursed first, i.e. the issue of goods is done from the latest lot and the stock in hand comprise of the newest batch.

 

LIFO Example:

Lets see this example, In a cylindrical box, we have dropped 3 balls one after another firstly Red ball, followed by Yellow and Blue balls. If you need to empty this box, you need to take out the Blue ball first which was dropped last. Here Last-In, First-Out (LIFO) method is followed wherein last unit to arrive in box or more recent to take out first. But LIFO is not realistic for many companies because they would not leave the older inventory sitting idle in stock.

 

FIFO Example:

Lets see an example for First-In, First-Out (FIFO), A Ticket Checker in a Ticket Counter issues the ticket whomsoever came first to the counter, hence the oldest person in the Ticket Counter queue will get the chance to buy a ticket than the newest person who came last in the queue. Here FIFO method is followed and is the most logical choice, since companies typically use their oldest inventory first in the production of their goods.

 

	LIFO	FIFO
Definition	LIFO ( Last in First Out) method is an inventory valuation technique, in which the last received stock of goods is issued first.	FIFO (First in First Out) method is an inventory valuation technique, in which the first received stock of goods is issued first.
Stock in hand	It represents the oldest stock in hand	It represents the latest stock hand
Current market price	It is shown by the cost of goods sold	It is shown by the cost of unsold stock
Restrictions	There are restriction from IFRS	No such restriction from IFRS
Inflation	In Inflation condition - Income tax shows minimum amount.	In inflation condition - Income tax shows a higher amount.
Deflation	In Deflation condition - Larger amount of income tax is shown.	In Deflation condition - Reduced income tax will be shown
Record Maintained	Records maintained is high	Records maintained is less
Storage	Storage required compared to FIFO is high	Storage required compared to LIFO is less
Usage	Now a days LIFO is not used as it handles the latest stock in hand first which is unfair because the earliest stock stands in the queue.	Now days FIFO used as it is very simple to understand as well as to operate.
Examples	Aged Rice lots are sold last vs new rice lot because of the value generated by aged rice in stock. Similar to aged wine bottle ( Aged product price are high)	Selling of old stock of vegetable, Fruit first due to decay
	Generally product in Market/Shop shelf front row product place will be picked 1st by customer which was last product place in shelf.	Shop representative will always keep old stock in front of self and new stock backside in shell.

Inventory management system helps estimate Inventory value for stock sold versus stock left, considering the product flow (queue or stack).  Also, helps calculate the unit cost of sold goods and how to optimise sales at profitable rate.

 

Here is a brief summary of two popular methods with its differences:

 

	FIFO (FIRST IN FIRST OUT)	LIFO (LAST IN LAST OUT)
Definition	Oldest stock is used first, and new stock is the last one in queue	Newest stock is first to be purchased, Oldest stock goes to the back. Not for perishable products.
Examples	Pharmacy, Beverage & Other Business, Dairy Products	Retail firms – to sustain fashion trends, Real-estate , Gold & Diamond Business, Marble slab
Cost of Goods Sold (With a simple example)	Maximises profit, but Cost of Inventory goes up Week 1 (Produce): 100 Quantity for 10 $ Week 2 (Produce): 100 Quantity for 20 $ Week 3 (Produce) : 100 Quantity for 30 $ ------------------ Week 4 ( Sold – 200 Q for 40$): 100 Q x 10 $ 100 Q x 20 $        ------------------ Cost of Goods Sold: 3000 $ Profit : 5000 $	Reduces profit, which helps with reduced tax Week 1 (Produce): 100 Quantity for 10 $ Week 2 (Produce): 100 Quantity for 20 $ Week 3 (Produce) : 100 Quantity for 30 $ ------------------ Week 4 ( Sold – 200 Q for 40$): 100 Q x 30 $ 100 Q x 20 $            ------------------ Cost of Goods Sold: 5000 $ Profit : 3000 $
Flow of Goods	Cycle of buying and selling stocks is much easier. Simple to keep track of inventory balance.	Flow of goods in complex as old stock could stay for long on the system.
Record Keeping	As the older goods are sold, record keeping is reduced. Old stock does not get recounted or left for too long that its unusable	Complicated and confusing due to inventory layers, old stocks skew the value of inventory in balance sheets, older inventory sits for years and may never be sold
Inflation	As the initial cost of inventory is lower (usually) and selling price is higher.	Usually product price is going up, which would mean more profit for the old stock. However, this also means new products are more costly, and that effects profit margin.
Profit	Calculated profit shows more, leading to heavier taxes specially during inflation period. Diminishes company’s cash flow and growth opportunity.	Leads to less profit as price of product is also going up. LIFO will have less profit compared to FIFO, where product cost would have been lesser
Taxation	More profit leads to higher taxes. Miss out on tax advantages that LIFO has	Bigger tax advantage as goods sold are of higher cost, and low profit
Financial Reporting	Approved by International standards	IFRS does not allow this method. Mostly popular in US Industry
Account statement	Accounts based on costs from months or few years old, that makes forecast inaccurate	More accurate as LIFO reflects what is currently going on in the market. Investors want the most current forecast, prices for better investment decision.

 

Mainly LIFO is used to leverage taxation benefits to manage impact of inflation. As well LIFO supports investors with better investment decisions based on current market conditions. However, this is not approved by IFRS. Most businesses use FIFO for material flow to avoid old products stock up in the warehouse as well as easy physical flow of stocks.

For any business to be successful it is important to have a strong inventory.

It helps us to know what needs reordering and by when. it will help us to know how much stock we have left of an item and how it's performing in terms of selling.

It also helps is if the stock is moving and protects it from sitting idle in the warehouse.

We should also be curious to know that how much profit my stock is making, so it is not only just important for our record-keeping but also important from tax point of view.

 

There are two main methods of tracking stock and checking out a profit.

They are known as FIFO and LIFO.

FIFO means first in, first out. The oldest products in the inventory will be sold first and this is how production costs are calculated.

The LIFO means last in, first out. The most recent product/item in a company’s inventory gets sold first. It then applies these production costs.

 

Points to be considered when we go with the FIFO method:

• It's good for record-keeping
• Inflation will affect the tax
• Depression means you are paying less for stock
• The flow of goods makes this an easy method
• There are no restrictions on financial reporting
• There isn't much fluctuation.

 

Positives and negatives of FIFO:

Positives:

• Accurate in results
• Re-counting of old stock does not happen
• Inflation is also covered when FIFO is used.

 

Negatives:

• Higher amount of tax to be paid
• The high amount of data is required to gather the cost of goods, clerical errors can happen.
• FIFO can confuse profit results due to change in economic periods.

 

Points to be considered when we go with the LIFO method:

• Record keeping can be complicated.
• Inflation may affect old stock
• Devaluation may mean less profit
• This isn’t a very natural method

 

Positives and negatives of LIFO:

Positives:

• It keeps tax costs down
• Work well with retail firms who want to work with trends and quickly sell items that are in fashion now
• Helps to deal effectively with the fluctuating prices of food

 

Negatives:

• Record a lower profit
• The variation of prices means that keeping on top of your inventory value and all the layers can be complicated
• Difficult to keep on top of profit and tax payments.

FIFO – First In First Out

LIFO – Last In First Out

 

 

FIFO and LIFO are the two most common inventory cost methods companies use for the costs of purchased inventory on the balance sheet.

 

As Inventory plays a critical role in a business for financial management, it is likely that inventory is the largest asset category in terms of value. As inventory is the major current asset on the balance sheet of firms that sell products, These two methods gain most important aspect of the Inventory Management.

 

FIFO – First In First Out

 

This is the most preferred the method used by industries , It is specially used by companies where the inventories are perishable. The product has an expiry which will be expired with the time.In this method the material comes to warehouse/storage first will be exit first for the use.

 

It is one of the preferred method where the rising price tend is available. In this method where the prices trend goes up. It gives you opportunity to sell the lowest price product sold with current price. Which gives you high margin and high bottom line.

 

 

Example :

 

 In a ware house of Chemical Plant , The Raw material is coming every month and Assume the cost of the in coming RM goes up by 1.0 % every month. The RM coming to Jan is cost 1.0 Rs/Kg while RM come to Plant in Feb is 1.01 Rs/Kg and March is 1.02 Rs/Kg.

Also the RM has expiry of 6 month. Let us Understand how FIFO works. Assume we Receive 1000 KGS RM in month

 

 

If In March I sell the Material of Jan It help me to increase the bottom line (Profit ) of the companies and Also It support me to use the expiry of the product which expires after 6 month.

 

Above Example result shows below inferences

1.     The bottom line of the companies is goes up which help in investor and banks to support you in business environment.

2.     It increases your tax liability as profit is high.

3.     The process is better if Cost going down of product.

4.     This is most standard inventory method use worldwide for Accurate reference.

 

 

LIFO – Last In First Out

 

This is not the most preferred the method used by industries, The assumption is that the firm sells the last unit of inventory purchased first In this method the material comes to warehouse/storage last will be exit first for the use.

Changing Inventory method from FIFO to LIFO or vice versa impact major on your profit margin and support tax structure. So It is important to take approval for the same.

 

Example :

 

 Let us see the same example with LIFO

 

 

 

Above Example result shows below inferences

1.     The bottom line of the companies is down as compare to FIFO.

2.     As It goes down It also impact to reduce you tax liabilities.

3.     The process is better if Cost going up of product.

4.     This is not standard method across the world for Inventory management.

 

Now Where LIFO Used ?

Businesses that sell products that rise in price every year benefit from using LIFO , example like tobacco , Fuel Industries where the price has a rising trend they use LIFO to ( Irrespective of the our example where selling price we consider constant as 2.0 Rs Kg). It helps companies as price goes up the profit also goes up and support tax liability. Where they take benefits of High revenue as compare to bottom line.

First In First Out and Last In First Out commonly known as FIFO and LIFO are Inventory valuation methods.

First In First Out (FIFO) is a technique whereby sale or issue of goods from store is made from the oldest stick in hand. Also, referred as First In.

Last In First Out (LIFO) is the inventory valuation method basis the assumption that the last stock will be sold first.

 

                         FIFO                                                                        LIFO

 

 

Key differences between LIFO and FIFO-

FIFO has no restrictions against use by IFRS and GAAP while LIFO has restrictions against use by IFRS

FIFO decreases the number of records to be maintained, while LIFO increased the number of records

Advantages of FIFO and LIFO- FIFO is considered to be a lot more simplified system than LIFO. FIFO has ability to stabilize the cost of goods sold as the items in stick represent recent pricing. LIFO on the other hand, occurs in the scenario where deflation occurs in an economy whereby the value of the unsold items will increase and value of cost of goods sold will decrease resulting in high profits.

Disadvantages of FIFO and LIFO- FIFO increases taxable income with inflation in the costs of inventory also making it difficult to account for costs in instances where inventory is exchanged or returned. The main disadvantage of LIFO is the restriction against its use by IFRS, the discrepancy caused between the cost basis on initial inventory and the recent market price and the difficulties caused when interpreting current inventory activities as well as operating activities in a company.

In the nutshell, FIFO is generally preferred over LIFO system.

Examples:

FIFO:

In January a small business purchased 100 quantities of item A for $25 each and 50 quantities of item B for $15 each piece. In March, it purchases 25 more quantities of item A for $30 each and 125 more of item B for $20 each. It sells 50 items of B and 25 items A during the first quarter of the year, i.e. 75 items in all.

Using FIFO, the calculation of Cost of Goods Sold (based on plants purchased in Jan) will be-

50 item B x $15 ($750) + 25 item A x $25 ($625) = $1,375

LIFO:

Using LIFO, the calculation of Cost of goods sold will be-

50 item B x $20 ($1000) + 25 item A x $30 ($750) = $1,750

Hence, in FIFO, Cost of inventory is lower resulting in higher profit and more taxable income whereas, in LIFO, cost of inventory is higher resulting in lower profit and less taxable income.

 

Q. LIFO and FIFO are two commonly used methods for inventory management. Explain the differences between the two methods and provide examples where these are used.

 

Answer: LIFO and FIFO are the terms those are used in inventory management or cost of goods sold. Abbreviation for these two is “Last in First Out – LIFO” and “First in First Out - FIFO”.

 

FIFO – means the first item of the row / bucket will be sold out first from the inventory. In FIFO it is assumed that inventory items are sold in the order which they are manufactured or purchased. Means oldest inventory is sold first. FIFO method is generally adopted by most of the organizations which shows the actual flow of goods are manufactured.

For example: A grocery store buy the 10 cans of fresh juice every day. Owner will ensure to keep the juice in a manner that older one is in front of the shelf so that older one is picked first by customer. It will not let the older one wasted.

FIFO is mostly recommended for businesses that deal in consumable products.

Why FIFO?

1.       It is easy to use and follows the physical flow of inventory goods

2.       It has less wastage of goods, which shows the effective utilization of inventory.

 

LIFO – means the last item or more recent item purchased or manufactured in inventory to be sold out first. When the good’s price is increased, cost of goods sold is also higher in LIFO which reduces the inventory balance on lower side.

For example: The electronics dealer sells out the Air Conditioner in off season around 30K rupees but in summer season same AC will be sold out at 35K-38K. Using LIFO causes a firm’s cost of goods sold to increase and the net income to decrease.

LIFO is preferred in product-based companies which does not deal in consumable items.

Why LIFO?

1.       It complies with the matching principles as it charges costs with the revenue of a similar period

2.       Reduces the possibility of write-downs of inventory if their fair market value has decreased

LIFO generally leads to separate calculations which goes for extra manpower or extra efforts.

FIFO (First in, First Out) assumes that the first unit or the oldest unit of the inventory is first sold.  FIFO is widely used as companies sell products in the order in when they are purchase.

 

Example

 

A Company bought equipments on 2 seperate occassions which were at 2 different prices in a month

1) 500 equipments at $100

2) 800 equipments at $120

 

The company sold 400 equipments at the end of the month.  So after selling 400 equipments

COGS = (400 equipments * $100) = $40000

 

Remaining inventory value = (100 equipments * $100) + (800 * $120) = $106000

 

 

LIFO (Last in, Last Out) assumes that the last unit to get into the inventory would be the first to be sold.  Many companies may not leave their inventory sitting idle in stocks, hence LIFO might not be recommended.

 

After selling 400 equipments at the end of the month.

COGS = (400 equipments * $120) = $48000

Remaining inventory value = (500 equipments * $100) + (400 equipments * $120) = $98000

Method	FIFO Inventory Management	LIFO Inventory Management
Definition	FIFO,  First In First Out, inventory management means goods which are older or dated in the inventory are sold first in the order of priority	LIFO,  Last In First Out, inventory management means goods which are latest in the inventory are sold first in the order of priority
Industries where it is used?	It is generally used in perishable food items industry and rapidly changing industry like fashion industry, to keep up with the latest trends which are constantly changing and to avoid obsolesce in case of perishable food items	It is generally used in non-perishable commodities and industries like Petroleum, chemicals, metals etc.
How is Cost of Goods Sold calculated?	Beginning inventory (USD) + Total Purchases (USD) = Goods available for sale - Ending Inventory (from physical count) (USD) = Cost of goods sold (USD) However, the Cost of goods sold is calculated based on the price of old goods in the inventory	Beginning inventory (USD) + Total Purchases (USD) = Goods available for sale - Ending inventory (from physical count) (USD)  = Cost of goods sold (USD)   However, the Cost of goods sold is calculated based on the current prices of the goods in the inventory
Inventory value	FIFO is a good indicator of ending inventory value, therefore good valuation for business, as there is no wastage of inventory owing to getting obsolete	LIFO is not a good indicator of ending inventory value, as the old inventory might be extremely old and therefore might get obsolete
Margin	FIFO might show higher net income (as the old goods in the stock might have lesser prices or cost per unit)	LIFO might show lesser net income (as the newer goods in the stock might have higher prices or cost per unit, compared to the goods already in the stock) This higher price will be owing to inflation
Tax burden	FIFO method of inventory management might lead to higher net income and therefore will lead to higher tax burden for the company	LIFO method of inventory management might lead to lower net income and therefore will lead to lower tax burden for the company
Scenario in which it is most successful	FIFO is most successful in an industry where the price of product or goods does not change much or remains steady	LIFO is most successful in an industry where the price of product or goods fluctuates more frequently
Usage world wide	FIFO method of inventory management is most widely used across the world	LIFO method of inventory management is not used by countries following IFRS (International Financial Reporting Standards) as IFRS has banned it, However USA which follows GAAP (Generally Accepted Accounting Principles) principle, use it for accounting purpose
Example of how it is used?	A grocery store owner will always try to sell the milk cartons with nearest expiry date, first than the ones with later expiry date. This is to ensure that the goods do not get wasted	A petrol pump will always try to sell the petrol or diesel based on the recent market prices. This is to ensure that they do not incur the losses owing to rise in the fluctuating market

All the answers are so well written that reading through them was like revisiting the accounts books. Rahul Garg's answer has been selected as the best answer for the details captured and the examples quoted.