Do you routinely analyze your companies, but don't look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets. As a result, inventory is a critical component of the balance sheet. Therefore, it is important that serious investors understand how to assess the inventory line item when comparing companies across industries or in their own portfolios.
- The Last-In, First-Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first.
- The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.
- LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock.
- FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.
- Deciding between these two inventory methods as implications on a company's financial statements as this decision impacts the value of inventory, cost of goods sold, and net profit.
Inventory: FIFO, LIFO
What Is Inventory?
Inventory refers to a company's goods in three stages of production:
- Raw materials are basic goods used to be produced to generate finished products.
- Work-in-progress is items being manufactured but not yet complete.
- Finished inventory are items ready for sale that can be bought and delivered to consumers.
You can take the goods that the company has in the beginning of any given period, add the materials that it purchased to make more goods, subtract the goods that the company sold, cost of goods sold (COGS), and the result is the company's ending inventory.
Inventory accounting assigns values to the goods in each production stage and classifies them as company assets, as inventory can be sold, thus turning it into cash in the near future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:
BI+ Net Purchases −COGS=EIwhere:BI = Beginning inventoryEI = Ending Inventory
Understanding LIFO and FIFO
The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost. These methods are used to track the movement of inventory and record appropriate and relevant costs. The concept of LIFO and FIFO exists because a company must determine how to record the movement of its inventory. The amount a company pays for raw materials, labor, and overhead costs is continually changing. For this reason, the amount it cost to make or buy a good today might have been different than one week ago.
The LIFO and FIFO methods simply identify which item is sold first. Consider a company that spends $100 for an inventory item, then spends $150 on a second unit of the same inventory one week later. If the company sells one unit, should it record its cost of goods sold as $100 or $150?
It is up to the company to decide, though there are parameters based on the accounting method the company uses. In addition, companies often try to match the physical movement of inventory to the inventory method they use. The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows.
First-In, First-Out (FIFO)
The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory–or the oldest inventory–is the sold first. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on the balance sheet).
Last-In, First-Out (LIFO)
The Last-In, First-Out (LIFO) method assumes that the last or moreunit to arrive in inventory is sold first. 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.
The average cost method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
The average inventory method usually lands between the LIFO and FIFO method. For example, if LIFO results the lowest net income and the FIFO results in the highest net income, the average inventory method will usually end up between the two.
LIFO vs. FIFO: Inventory Valuation
The valuation method that a company uses can vary across different industries. Below are some of the differences between LIFO and FIFO when considering the valuation of inventory and its impact on COGS and profits.
Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete. 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 because they would not leave their older inventory sitting idle in stock while using the most recently acquired inventory.
For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products. In other words, the seafood company would never leave their oldest inventory sitting idle since the food could spoil, leading to losses.
As a result, LIFO isn't practical for many companies that sell perishable goods and doesn't accurately reflect the logical production process of using the oldest inventory first.
FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most recently acquired items reflect current market prices. For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.
For example, the seafood company, mentioned earlier, would use their oldest inventory first (or first in) in selling and shipping their products. Since the seafood company would never leave older inventory in stock to spoil, FIFO accurately reflects the company's process of using the oldest inventory first in selling their goods.
LIFO and FIFO: Impact of Inflation
If inflation were nonexistent, then all three of the inventory valuation methods would produce the same exact results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, our bakery example from earlier would be able to produce all of its bread loaves at $1, and LIFO, FIFO, and average cost would give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period.
Assuming that prices are rising, inflation would impact the three inventory valuation methods as follows:
When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from a lower tax liability.
When sales are recorded using the FIFO method, the oldest inventory–that was acquired first–is used up first. FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS. However, the higher net income means the company would have a higher tax liability.
The average cost method produces results that fall somewhere between FIFO and LIFO.
However, please note that if prices are decreasing, the opposite scenarios outlined above play out. In addition, many companies will state that they use the "lower of cost or market" when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO, or average cost.
The LIFO inventory method is not allowed under IFRS.
LIFO and FIFO: Financial Reporting
Companies outside of the United States that use International Financial Reporting Standards (IFRS) are not permitted to use the LIFO method. Companies within the U.S. have greater flexibility on the method they may choose and can opt for either LIFO or FIFO.
Though the LIFO inventory method does require a robust inventory management system to track different inventory transactions, LIFO systems often require less demand on historical data as the most recent purchases are sold first. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method as once early inventory is booked, it may remain on the books untouched for long periods of time.
In addition to being allowable by both IFRS and GAAP users, the FIFO inventory method may require greater consideration when selecting an inventory method. Companies that undergo long periods of inactivity or accumulation of inventory will find themselves needing to pull historical records to determine the cost of goods sold. Though many accounting systems can automate this process, the bookkeeping requirements under the FIFO method result in transactions that continually turnover and do not remain on the books for as long compared to the LIFO method.
LIFO and FIFO: Taxes
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. Under the LIFO method, expenses are highest. This means taxable net income is lower under the LIFO method and the resulting tax liability is lower under the LIFO method.
In contrast, taxes are usually higher under the FIFO method. 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.
LIFO and FIFO: Advantages and Disadvantages
When a company selects its inventory method, there are downstream repercussions that impact its net income, balance sheet, and ways it needs to track inventory. Here is a high-level summary of the pros and cons of each inventory method. All pros and cons listed below assume the company is operating in an inflationary period of rising prices.
Pro: LIFO results in lower tax liability compared to other methods.
Pro: LIFO may be easiest to implement if inventory is easily accessible because it has been recently purchaed.
Con: LIFO often does not represent the actual movement of inventory (i.e. many companies try to move older inventory).
Con: LIFO results in lower net income compared to other methods.
Pro: FIFO results in higher net income compared to other methods.
Pro: FIFO often results in higher inventory balances compared to other methods, strengthening a company's balance sheet.
Con: FIFO results in a higher tax liability compared to other methods.
Con: FIFO may not accurately communicate the true cost of materials if inventory has been stagnant while prices have risen.
Example of LIFO vs. FIFO
In the tables below, we use the inventory of a fictitious beverage producer called ABC Bottling Company to see how the valuation methods can affect the outcome of a company’s financial analysis.
The company made inventory purchases each month for Q1 for a total of 3,000 units. However, the company already had 1,000 units of older inventory that was purchased at $8 each for an $8,000 valuation. In other words, the beginning inventory was 4,000 units for the period.
The company sold 3,000 units in Q1, which left an ending inventory balance of 1,000 units or (4,000 units - 3,000 units sold = 1,000 units).
|ABC CO. — MONTHLY INVENTORY PURCHASES|
|Month||Units Purchased||Cost / Each||Value|
|3,000 = Total Purchased|
|ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCH|
|Sales = 3,000 units @ $20 each||$60,000||$60,000||$60,000|
- Under LIFO, COGS was valued at $37,000 because the 3,000 units that were purchased most recently were used in the calculation or the January, February, and March purchases ($10,000 + $12,000 + $15,000).
- Under FIFO, COGS was valued at $30,000 because FIFO uses the oldest inventory first and then the January and February inventory purchases. In other words, the 3,000 units comprised of (1,000 units for $8,000) + (1,000 units for $10,000 or Jan.) + (1,000 units for $12,000 or Feb.)
- The average cost method resulted in a valuation of $11,250 or (($8,000 + $10,000 + $12,000 + $15,000) / 4).
Below are the Ending Inventory Valuations:
- Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that the last units in (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
- Ending Inventory per FIFO: 1,000 units x $15 each = $15,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
- Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)] / 4000 units = $11.25 per unit; 1,000 units X $11.25 each = $11,250. Remember that we take a weighted average of all the units 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 important items to analyze because it can provide insight into what's happening with a company's core business.
Major Differences - LIFO and FIFO (During Inflationary Periods)
The newest inventory item is the first item to be sold.
Net income is often lower.
Cost of goods sold is often higher.
Ending inventory on the balance sheet is often lower.
LIFO often does not represent the actual movement of inventory (as companies try to sell the items at the most risk of obsolescence).
The oldest inventory item is the first to be sold.
Net income is often higher.
Cost of goods sold is often lower.
Ending inventory on the balance sheet is often higher.
FIFO more closely represents the actual movement of inventory (as companies try to sell the items at the most risk of obsolescence).
Is FIFO a Better Inventory Method Than LIFO?
FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this results in higher tax liabilities and potentially higher future write-offs if that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory.
Does IFRS Permit LIFO?
No, the LIFO inventory method is not permitted under International Financial Reporting Standards (IFRS). Both the LIFO and FIFO methods are permitted under Generally Accepted Accounting Principles (GAAP).
What Types of Companies Often Use LIFO?
Companies often use LIFO when attempting to reduce its tax liability. LIFO usually doesn't match the physical movement of inventory, as companies may be more likely to try to move older inventory first. However, companies like car dealerships or gas/oil companies may try to sell items marked with the highest cost to reduce their taxable income.
What Types of Companies Often Use FIFO?
Companies with perishable goods or items heavily subject to obsolescence are more likely to use LIFO. For example, consider a grocer selling produce. Logistically, that grocery store is more likely to try to sell slightly older bananas as opposed to the most recently delivered. Should the company sell the most recent perishable good it receives, the oldest inventory items will likely go bad.
In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. For example, a chip manufacturer may want to ensure older units of a specific model are moved out of inventory while more recently manufacturer units of the same model may be able to better withhold storage conditions.
The Bottom Line
Companies have their choice between several different accounting inventory methods, though there are restrictions regarding IFRS. Two of these options are LIFO and FIFO. Companies that opt for the LIFO method sell the most recent inventory times which usually cost more to obtain or manufacture, while the FIFO method results in a lower cost of goods sold and higher inventory. A company's taxable income, net income, and balance sheet balances will all vary based on the inventory method selected.
Federal Reserve Bank of St. Louis. "Consumer Price Index for All Urban Consumers: All Items in U.S. City Average."