The first-in, first-out (FIFO) inventory cost method assumes the oldest inventory is sold first. This leads to minimizing taxes if the prices of inventory items are falling. In this situation, the prices of the items purchased first are higher because the prices are downward trending and hence the cost of the previously purchased items of inventory (i.e. the first inventory in) is higher. This results in a higher company's cost of goods sold (COGS). Last-in, first-out (LIFO) assumes the most recent inventory purchases are sold first.
Using the higher inventory costs (first in) would lead to a lower reported net income or profit for the accounting period (versus last out). As a result, the lower net income would mean the company would report a lower amount of profit used to calculate the amount of taxes owed.
- If a company uses the FIFO inventory method, the first items purchased and placed in inventory are the ones that were first sold.
- If the older inventory items were purchased when prices were higher, FIFO would lead to a higher cost of goods sold and lower net income when compared to LIFO.
- Lower net income would mean less taxable income and ultimately, a lower tax expense for that accounting period.
Understanding First-in, First-out (FIFO)
When companies generate their financial statements, they must calculate the revenue generated from sales, the costs that went into production (or COGS), and also the profit earned for that time period. A company would take the revenue total and subtract the inventory costs (as well as other expenses), to determine how much profit was earned.
Companies must determine which items in inventory were used up in generating the sales for that accounting period as well as the costs of those inventory items. If a company uses the FIFO inventory method, the first items that were purchased and placed in inventory are the ones that were first sold. As a result, the inventory items that were purchased first are recorded within the cost of goods sold, which is reported as an expense on the company's income statement.
In other words, with the FIFO method, the oldest inventory will be used in determining the cost of goods sold. When sales are recorded for the accounting period, the costs of the oldest inventory items are subtracted from revenue to calculate the profit from those sales.
First-in, First-out (FIFO) and Taxes
Although companies want to generate higher profits with each passing year, they also want to reduce their taxable income. If a company's inventory costs rose by 50%, for example, the company would report a lower amount for net income, assuming sales prices weren't increased to counter the higher inventory expense. A lower net income total would mean less taxable income and ultimately, a lower tax expense for the year.
The FIFO method can help lower taxes (compared to LIFO) when prices are falling. However, for the most part, prices tend to rise over the long term, meaning FIFO would produce a higher net income and tax bill over the long term.
If the older inventory items were purchased when prices were higher, using the FIFO method would benefit the company since the higher expense total for the cost of goods sold would reduce net income and taxable income. The newer, less expensive inventory would be used later, meaning the company would report a higher profit in later accounting periods and a higher taxable income—all else being equal.
However, prices tend to rise over the long term, meaning that FIFO may not minimize taxes for a company. In a rising-price environment over the long term, the older inventory items would be the cheapest, while the newer, recently purchased inventory items would be more expensive.
FIFO would only minimize taxes in periods of declining prices since the older inventory items would be more expensive than the most recently purchased items. It's best to consult a tax professional before determining the best methods for reducing taxable income since there are many components that go into calculating a company's tax liability.