FIFO vs LIFO | Examples | Advantages | Must know Differences

FIFO vs LIFO

FIFO vs LIFO | Examples | Advantages | Must know Differences – FIFO (First In, First Out) and LIFO (Last In, First Out) are two methods of accounting for the value of inventory held by the company. By accounting for the value of the inventory it becomes practicable to report the cost of goods sold or any inventory related expenses on the Profit and Loss Statement and to report the value of Inventory of any kind on the balance sheet.

In this article, we look at what is LIFO and FIFO, examples, advantages and its key differences –

Definitions of FIFO and LIFO methods


walmart-fifo-vs-lifo-example

What is FIFO (first in first out)?

FIFO stands for First In, First Out which implies that the inventory which was added first to the stock will be removed from stock first. So the inventory will leave the stock in an order same as that in which it was added to the stock.

It means that whenever the inventory will be reported as sold (either after conversion to finished goods or as it is) its cost will be taken equal to the cost of the oldest inventory present in the stock.

This, in turn, means that the cost of inventory sold as reported on the Profit and Loss Statement will be taken as that of the oldest inventory present in the stock. On the other hand, on the Balance Sheet, the cost of the inventory still in stock will be taken equal to the cost of the latest inventory added to the stock.

What is LIFO (last in first out)?

LIFO stands for Last In, First Out which implies that the inventory which was added last to the stock will be removed from the stock first. So the inventory will leave the stock in an order reverse of that in which it was added to the stock.

It means that whenever the inventory will be reported as sold (either after conversion to finished goods or as it is) its cost will be taken equal to the cost of the latest inventory added to the stock.

This, in turn, means that the cost of inventory sold as reported on the Profit and Loss Statement will be taken as that of the latest inventory added to the stock. On the other hand, on the Balance Sheet, the cost of the inventory still in stock will be taken equal to the cost of the oldest inventory present in the stock.

Both these methods are purely methods of accounting for and reporting the value of inventory. Whichever method is adopted, it does not govern the actual addition or removal of inventory from the stock for further processing or selling.

Another inventory cost accounting method that is also widely used by both public and private companies is the Average Cost method. This method takes the middle path between FIFO and LIFO by taking the weighted average of all units available in the stock during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

But in this article, our focus is only on the FIFO and LIFO methods of inventory cost accounting and the comparison between the two.

LIFO vs FIFO Example


Suppose that a company produces and sells its product in batches of 100 units. If the inflation is positive, the cost of production will go on increasing with time. So assume that 1 batch of 100 units is produced within each time period and the cost of production increases after each successive period.

So if the cost of production for producing 1 unit is $ 10 in the first period, it could be $ 15 in the second period, $ 20 in the second period and so on. This is summarized in the table below:

Batch No. Number of units Cost of production per unit ($)
1 100 10
2 100 15
3 100 20
Total 300 4500

Consider the details about the three batches of production given in the above table. Suppose the batch numbers are in order of date of production of the batches.

It should be obvious that the company won’t be able to sell exactly 100 units of products during each period.  It will have to sell them as per the orders it receives and also as per the availability of the products in its stock of finished goods. So suppose that the company gets orders of a total of 150 units after producing the 3rd batch of 100 units.

Inventory Valuation using FIFO method

Now, if a company chooses to use the FIFO method of inventory accounting, the cost of goods sold will be taken equal to the cost of the first 150 units produced (remember “first in, first out”?) out of all the 300 units available in the stock. Now, the first 150 units produced include the 100 units of Batch No. 1 plus any 50 units of Batch No. 2. Hence, the Cost of Goods Sold (COGS) will be equal to (100 * $ 10) + (50 * $ 15) = $ 1750.

Also, the value of the remaining inventory of the finished products will be equal to the cost of the remaining 150 units in the stock i.e. the remaining 50 units of Batch No. 2 and the 100 units of Batch No. 3. Hence, the value of Inventory of finished goods that will be reported on the Balance Sheet of the company would be equal to (50 * $ 15) + (100 * $ 20) = $ 2750.

Inventory Valuation using LIFO method

Now, if a company chooses to use the LIFO method of inventory accounting, the cost of goods sold will be taken equal to the cost of the last 150 units produced (remember “last in first out”?) out of all the 300 units available in the stock. Now, the last 150 units produced include the 100 units of Batch No. 3 plus any 50 units of Batch No. 2. Hence, the Cost of Goods Sold (COGS) will be equal to (100 * $ 20) + (50 * $ 15) = $ 2750.

Also, the value of the remaining inventory of the finished products will be equal to the cost of the remaining 150 units in the stock i.e. the remaining 50 units of Batch No. 2 and the 100 units of Batch No. 1. Hence, the value of Inventory of finished goods that will be reported on the Balance Sheet of the company would be equal to (50 * $ 15) + (100 * $ 10) = $ 1750.

Why are there more than one method for inventory cost accounting? 


The root cause why are there more than one method for the purpose of accounting for the cost of inventory is inflation. If inflation, somehow, ceases to exist then we won’t require different methods to find out the value of inventory a company expense or keeps in its warehouses.

This is because if inflation is not there, the cost of material purchased today would be exactly equal to that purchased last year. So the material cost going into the production of finished goods will also come out to be the same for a particular type of products. So the cost of the inventory added to the stock today will be exactly equal to the cost of the inventory added to the stock one year ago. Hence, whether you use LIFO method or FIFO method, the value of the inventory expensed or even that in stock will also come out to be exactly the same in any case.

But since inflation is a reality, the value of inventory comes out to be something when we use FIFO and it comes out to be something else when we use LIFO.

Still, why do some companies use FIFO while some use LIFO for calculating the value of inventory? The answer to this is this: Companies use different methods of inventory accounting for the benefits and convenience offered by both methods in different situations.

While the above is true, in most of the countries, the IFRS accounting standards are followed which do not allow the usage of the LIFO method. So there the companies do not have that choice.

FIFO IAS2

source: iasplus.com

But in the US it is allowed with a condition that publicly traded entities that use LIFO for taxation purposes must use LIFO for financial reporting also.

Also, look at IFRS vs US GAAP

LIFO vs FIFO – Which is preferred?


The value of inventory appears on the Income Statement as Cost of Goods Sold (COGS) and on the Balance Sheet as Inventory under Current Assets. Thus the method used for the valuation of inventory will indirectly affect the value of Gross Income, Net Income, Income Tax on the Income Statement and Current Assets and Total Assets on the Balance Sheet.

To understand this, let’s take the values of Cost of Goods Sold (COGS) and that of the Inventory calculated using both the FIFO as well as the LIFO methods from the Illustrative Example discussed above.

Advantages of LIFO


First take the values of COGS calculated using both the methods and prepare an Income Statement assuming all other values like Sales, Other Expenses and Tax Rate to be the same for both the methods. For the purpose of assumption, let the selling price of 1 unit be $ 40. Since a total of 150 units were sold, the total Sales will come out to be (150 * $ 40) = $ 6000. Also suppose that the Other Expenses for the period under consideration totaled $ 1250 and the Tax Rate applicable on the Net Income was 30 %. And let these assumed values to be the same for both methods.

The Income Statement prepared when both FIFO and LIFO are used will look like the following:

Using FIFO Method Using LIFO Method
Sales ($) 6000 6000
COGS ($) 1750 2750
Gross Income ($) 4250 3250
Other Expenses ($) 1250 1250
Net Income ($) 3000 2000
Tax Rate 30% 30%
Income Tax ($) 900 600

The value of COGS calculated using the FIFO method was $ 1750 while that calculated using the LIFO method was $ 2750. Now look at the differences between the values of Gross Income, Net Income and Income tax. All of that is due to the difference in the values of COGS which in turn is due to the use of two different methods (FIFO and LIFO) of inventory valuation.

So ultimately the benefit of using the LIFO method for a company is that it can report a lower Net Income and hence defer its tax liabilities during the times of high inflation. But at the same time, it might end up disappointing the investors by reporting lower earnings per share. On the other hand, a company which uses the FIFO method will be reporting a higher net income and hence will have a greater amount of tax liability in the near term.

In addition to tax deferment, LIFO is beneficial in lowering the instances of inventory write-downs. Inventory write-downs happen if the inventory is deemed to have decreased in price below its carrying value. If LIFO is used, only old inventory will remain in stock and its purchase price will have a lesser chance of going below its carrying value.

Advantages of FIFO


Now, to understand the impact of both the methods on the Balance Sheet, take the values of Inventory calculated using both the methods and prepare the Balance Sheet in its simplest form assuming the values of Other Assets (all assets other than the inventory) and Total Liabilities to be the same for both the methods. For the purpose of assumption, let the value of Other Assets be $ 20000 and the value of Total Liabilities be $ 10750. And let these assumed values are the same for both methods.

The Balance Sheet prepared when both FIFO and LIFO are used will look like the following:

Using FIFO Method
Assets Liabilities
Inventory ($) 2750 Total Liabilities ($) 10750
Other Assets ($) 20000
Total Assets ($) 22750 Share Holders’ Equity ($) 12000

 

Using LIFO Method
Assets Liabilities
Inventory ($) 1750 Total Liabilities ($) 10750
Other Assets ($) 20000
Total Assets ($) 21750 Share Holders’ Equity ($) 11000

The value of Inventory calculated using the FIFO method was $ 2750 while that calculated using the LIFO method was $ 1750. Now look at the differences between the values of Total Assets and Shareholders’ Equity (=Total Assets-Total Liabilities). All of that is due to the difference in the values of Inventory which in turn is due to the use of two different methods (FIFO and LIFO) of inventory valuation.

So ultimately the benefit of using the FIFO method for a company is that it can report a higher value of Shareholders’ Equity or Net Worth and hence appear more attractive to the investors. On the other hand a company which uses the LIFO method will be reporting a lower value of Net Worth and hence will appear comparatively less attractive to the investors.

It should be obvious to the reader but is also noteworthy that the impact on the COGS in the Income Statement and Inventory in the Balance Sheet will be as described above only if the inflation is positive i.e. the prices of raw materials are increasing with time. If inflation is negative, the impact of LIFO and FIFO will be reverse of what is described above.

FIFO vs LIFO – Summary


The crux of the above explanation is summarized in the following table:

FIFO LIFO
Material Flow Material purchased first is used first. Material purchased last is used first.
During inflation Low COGS hence high tax. High Inventory values hence higher Net Worth. Higher earnings and higher Net Worth attract investors. High COGS hence low tax. Low Inventory values hence lower Net Worth. Lower earnings and lower Net Worth repel investors.
Deflation High COGS hence low tax. Low Inventory values hence lower Net Worth. Lower earnings and lower Net Worth repel investors. Low COGS hence high tax. High Inventory values hence higher Net Worth. Higher ea rnings and higher Net Worth attract investors.
Restrictions on usage No restrictions by any accounting standard. IFRS does not allow using LIFO for accounting.
Record keeping The oldest items are sold first. So the number of records to be maintained decreases. The newest items are sold first. So the oldest items may remain in the inventory for many years. This increases the number of records to be maintained.
Fluctuations in reporting There are only recently purchased items present in the inventory. So the COGS does not fluctuate. It increases smoothly depending upon the inflation. There could be very old items present in the inventory. So the COGS may fluctuate when those old items form part of the goods sold by the company.
Inventory write-downs More probable. Very less probable.

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Conclusion


FIFO and LIFO are two methods of accounting and reporting the value of inventory. FIFO takes the cost of materials purchased first as the cost of goods sold and the cost of materials purchased last as the cost of items still present in the inventory. LIFO takes the cost materials purchased most recently as the cost of goods sold and the cost of materials purchased first as the cost of items still present in the inventory.

The benefits of using LIFO method are that it is helpful in deferring tax and lowering inventory write-downs during periods of high inflation. The benefit of using FIFO is that it results into higher value of reported earnings and the company’s Net Worth attracting more investors. These effects are completely opposite when there is deflation.

But in most countries the IFRS standard is enforced under which using LIFO is not allowed. Only few countries including the US allow the usage of LIFO for taxation purposes but also require its usage while reporting the results to the investors. However, FIFO is a much more popular method out of the two because of being more logical for most industries.

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