Inventory accounting is a huge part of managing a business, especially in the realm of e-commerce. Accurate inventory valuation is critical so business owners should do more than punch numbers into software and hope for the best. There are several ways to value a business’s inventory and which method is best is determined by the needs of the business.
The two most common methods of inventory valuation are first-in-first-out (FIFO), and last-in-first-out (LIFO). Each method has benefits that need to be considered when choosing which is best for your business. It is critical to understand inventory and how these processes impact your business’ workflow and profitability, so keep reading for more information on FIFO, LIFO, and beyond.
What is Inventory?
Before getting into the details of FIFO and LIFO, it is important for business owners to understand what counts as inventory. In the most basic terms, inventory is any of the company’s goods that are in the three major stages of products. These stages include:
Raw materials.
Goods that are currently in production.
Finished goods ready for sale.
To identify inventory value, business owners should take the value of the company’s initial goods, add the cost of any goods purchased to produce more, and then subtract the goods that the company has sold. The remaining value is the inventory.
First-In, First-Out (FIFO) Explained
FIFO plays a major role in determining the cost of goods sold (COGS). As the name suggests, FIFO is a means of determining which goods should be sold first. In other words, the goods that are the oldest should be the goods that are first sold. Products that are sold using the FIFO method include perishables like produce, dairy, dry grocery goods, alcohol, plants, and health care products.
Industries Where FIFO is Commonly Used
Food and Beverage
FIFO ensures perishable goods are sold before they expire.
Pharmaceuticals
For medicines with expiration dates, FIFO minimizes waste.
Retail
Particularly in fashion and electronics, FIFO helps avoid obsolescence as trends and technology evolve.
Agriculture
Products like fruits and vegetables require FIFO to ensure freshness.
Advantages of FIFO
1. Easier Tracking of Inventory
Since the oldest items are sold first, inventory management becomes more straightforward.
Aligns naturally with physical flow in most businesses.
2. Reflects Current Market Prices on the Balance Sheet
Ending inventory is valued at the cost of the most recent purchases, which often aligns closely with current market prices.
Provides a more accurate representation of the company’s financial position.
3. Lower Risk of Obsolescence
Older items are sold first, reducing the likelihood of products becoming outdated or unsellable.
Particularly beneficial in industries dealing with perishables or rapidly changing products.
Disadvantages of FIFO
1. Higher Taxable Income During Inflation
Selling older, lower-cost inventory while keeping higher-cost inventory on the books results in higher reported profits.
Higher profits lead to increased tax liabilities during inflationary periods.
2. May Not Reflect True Cost of Goods Sold in Rising Cost Environments
During inflation, the cost of goods sold (COGS) reflects older, lower costs, which might not align with the actual expenses of replacing inventory.
This can distort profitability metrics and financial planning.
Last In-First, Out (LIFO) Explained
Like FIFO, LIFO is another inventory valuation method used to determine which products should be sold first. With LIFO, the most recent inventory is the first to be sold rather than the last. This is a fine method to use so long as the goods are not in danger of spoiling or becoming obsolete.
LIFO often requires more complex formulas to determine profitability at the end of a fiscal cycle. In this method, new inventory is worth more than what has not yet been sold. The cost of inventory is higher, so profits are lower. Products that are sold using LIFO include cars, gas, jewelry, and oil.
Industries Where LIFO is Commonly Used
Manufacturing
Used to manage inventory with rising material costs, such as metals, chemicals, or components. Helps align costs with current production expenses.
Retail
Particularly in industries with fluctuating product costs (e.g., electronics, construction supplies). Reduces taxable income by expensing higher-cost inventory first during inflation.
Oil and Gas
In industries with volatile prices for raw materials, LIFO helps match high costs to revenue during inflationary periods.
Can lead to significant tax savings for businesses in inflationary environments.
2. Better Matches Current Costs with Revenues
The cost of goods sold reflects the most recent inventory costs, which aligns with the revenue generated.
Provides a clearer picture of profitability in periods of fluctuating costs.
Disadvantages of LIFO
1. Complicated to Manage
Requires detailed record-keeping to track inventory layers.
Administrative burden is higher compared to FIFO.
2. Not Accepted Under International Financial Reporting Standards (IFRS)
Companies operating internationally cannot use LIFO, as IFRS only permits FIFO or weighted average methods.
Limits its applicability for global businesses.
3. May Undervalue Inventory on the Balance Sheet
Ending inventory is based on the cost of older, often cheaper inventory, which can understate the true market value.
This can negatively affect the financial position presented to investors.
The Difference Between LIFO and FIFO
There are a few primary differences between how LIFO and FIFO work that should be noted. Essentially, the flow of goods, how the stock is calculated for profits and tax purposes, and how inventory is processed are different depending on which method is used.
FIFO and LIFO are both perfectly acceptable methods of inventory valuation, so it is up to the business which method works best for their products. It is worth noting that international standards only permit the use of the FIFO method to calculate the cost of goods sold.
What to Consider When Choosing an Inventory Valuation Method
So long as a business does not operate according to international standards, there is no wrong method for inventory valuation. To determine which method is best for your business, consider the following:
Products
The very first thing to consider before choosing LIFO or FIFO for your business is what types of products you are selling. Perishable items like those listed above cannot be sold using LIFO, as the older inventory will degrade to the point of no longer being consumable and the product is just wasted. LIFO is used for inventory that is not affected by time.
Flow of Goods
Businesses often prefer FIFO because it closely resembles the actual flow of goods. In other words, it is a highly intuitive means of moving products. It is simpler than LIFO and results in less waste. However, for industries like coal and natural gas, LIFO is more closely related to the natural flow of goods.
Tax Purposes
Businesses sometimes choose LIFO for its tax advantages. Because the cost of goods sold is higher when using the LIFO method, it decreases a business’s overall profits. When the business reports lower profits, it reduces its tax liability. FIFO works conversely, making it more likely that companies will have a higher tax liability when using this method.
Inventory
FIFO works under the assumption that goods are continually being sold and that older stock is moved out as sales are made. On the other hand, LIFO is more focused on the new inventory and operates under the assumption that older goods will remain in stock over a longer period.
It is important to note that LIFO often minimizes write-downs. An inventory write-down is a process that shows when goods lose value enough that the market value drops below the initial book value. For example, if a piece of tech is obsolete and the value is no longer what it was when it was first produced, then it would result in an inventory write-down.
Accounting Calculations
LIFO and FIFO differ in how financial losses and gains are calculated. While inflation may be a factor that affects both methods, FIFO allows businesses to keep older stock valued at the current market price. To calculate FIFO inventory cost, determine the cost of the oldest inventory and multiply it by the number of items sold. When using LIFO, the most recent stock is valued higher than the older stock when the price increases.
Business Size and Industry
Smaller businesses often prefer FIFO due to its simplicity and alignment with natural inventory flow. Larger enterprises may choose LIFO for tax advantages if managing higher inventory levels during inflation.
FIFO is ideal for industries dealing with perishables (e.g., food, pharmaceuticals). While LIFO suits industries where raw material costs fluctuate significantly (e.g., manufacturing, oil and gas).
Regulatory Requirements (e.g., GAAP vs. IFRS Compliance)
Companies operating globally must ensure compliance with local accounting standards when choosing a method.
GAAP Compliance
LIFO and FIFO are both accepted under Generally Accepted Accounting Principles (GAAP) in the U.S.
IFRS Compliance
LIFO is not permitted under International Financial Reporting Standards (IFRS), limiting its use for multinational companies.
Current Economic Conditions (e.g., Inflationary Trends)
Inflation
LIFO can help businesses minimize taxable income by matching rising costs to current revenues during inflation. FIFO may increase taxable income during inflation as older, lower-cost inventory is recorded as the cost of goods sold.
Deflation or Stable Pricing
FIFO is often preferred in stable or deflationary periods as it better reflects actual inventory value.
Inventory Valuation and E-Commerce
FIFO is the most popular method of inventory valuation for e-commerce businesses due to its simplicity and logical flow. However, it is still difficult to accurately determine the value of an ecommerce business’s goods, as it is more difficult for accurate record keeping. However, inventory valuation accounting software can help keep the records straight, so profits and losses are easy to determine.
Success with eCommerce hinges on efficiency and a streamlined inventory valuation system. The best way to make this happen is to hire a company that has a well-developed and experienced system built to handle the needs of an eCommerce business. Using an established and tested system like this, inventory management and valuation will be far less of a headache than it has been in the past.
How to Calculate FIFO and LIFO
Here’s how you can calculate FIFO (First In, First Out) and LIFO (Last In, First Out) for inventory:
1. FIFO Calculation
FIFO assumes the oldest inventory is sold first.
Steps to Calculate FIFO:
List the inventory purchases and their costs in chronological order.
Match the cost of the oldest inventory items to the number of units sold.
Calculate the total cost of goods sold (COGS) using the costs of the oldest inventory items.
Calculate the ending inventory using the most recent purchase costs for the remaining items.
Example:
Purchases:
100 units @ $10 each = $1,000
150 units @ $12 each = $1,800
200 units @ $14 each = $2,800
Units Sold: 250
COGS Calculation (FIFO):
100 units @ $10 = $1,000 (oldest inventory)
150 units @ $12 = $1,800
Total COGS = $2,800
Ending Inventory:
50 units remaining @ $14 = $700
2. LIFO Calculation
LIFO assumes the newest inventory is sold first.
Steps to Calculate LIFO:
List the inventory purchases and their costs in chronological order.
Match the cost of the most recent inventory items to the number of units sold.
Calculate the total COGS using the costs of the newest inventory items.
Calculate the ending inventory using the oldest purchase costs for the remaining items.
Example:
Purchases:
100 units @ $10 each = $1,000
150 units @ $12 each = $1,800
200 units @ $14 each = $2,800
Units Sold: 250
COGS Calculation (LIFO):
200 units @ $14 = $2,800 (newest inventory)
50 units @ $12 = $600
Total COGS = $3,400
Ending Inventory:
100 units @ $10 = $1,000
100 units @ $12 = $1,200
Total Ending Inventory = $2,200
Key Differences
FIFO results in lower COGS and higher net income in periods of inflation (but higher taxes).
LIFO results in higher COGS and lower net income in periods of inflation (but lower taxes).
The Bottom Line
The difference between LIFO and FIFO can be considerable depending on the industry. Knowing how to manage inventory is a critical component of a successful company, no matter its size. Managing inventory well can help companies forecast their earnings and can ensure a company is running efficiently. For the best chance at success, while minimizing the logistical headache of inventory management, companies should consider using a professional inventory valuation system.
