Finally, the model makes an implicit assumption that inventory is always replenished at a constant rate. In theory, if a company reduces its inventory levels and continues to sell out older inventory before making new purchases, the effect of the chosen inventory costing method on the company’s income statement may differ. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management’s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.
Real-World Example: Applying LIFO in Inventory Management
For example, let’s say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each and produces 200 more on Tuesday at $1.25 each. According to the rules of FIFO, if the bakery sells 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each the inventory costing method that results in the lowest taxable income in a period of rising costs is: of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory on the balance sheet.
LIFO compares sales to the purchase price of the most recently bought inventory. All four methods of inventory costing are acceptable; no single method is the only correct method. This is why LIFO creates higher costs and lowers net income in times of inflation.
Understanding LIFO: Last In, First Out Inventory Method
- The resulting gross margin is a better indicator of management’s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.
- During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs.
- In contrast, firms use coal stacked in a pile in a LIFO manner because the newest units purchased are unloaded on top of the pile and sold first.
LIFO supporters contend that the increased usefulness of the income statement more than offsets the negative effect of this undervaluation of inventory on the balance sheet. It illustrates how using LIFO not only results in the most equitable outcome to all stakeholders, it also contributes to the ongoing sustainability of the business. Furthermore, it demonstrates how, while companies using FIFO may present higher earnings numbers, once adjusted for inventory replacement cost, economic earnings are lower than they would be under LIFO.
Major Differences—LIFO and FIFO (During Inflationary Periods)
If we switch inventory methods, we must restate all years presented on financial statements using the same inventory method. The third criticism—that LIFO permits income manipulation—is also valid. The company could purchase an abnormal amount of goods at current high prices near the end of the current period, with the purpose of selling the goods in the next period. Under LIFO, these higher costs are charged to cost of goods sold in the current period, resulting in a substantial decline in reported net income. To obtain higher income, management could delay making the normal amount of purchases until the next period and thus include some of the older, lower costs in cost of goods sold. Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that prices have risen almost constantly for decades.
Why Keep Using (or Switch to) FIFO?
In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income. Based on the LIFO method, the last inventory in is the first inventory sold. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100.
The Trade-Offs of Valuation Methods
On the other hand, LIFO often charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net income by changing the timing of additional purchases. One disadvantage of the specific identification method is that it permits the manipulation of income. For example, assume that a company bought three identical units of a given product at different prices. One unit cost $ 2,000, the second cost $ 2,100, and the third cost $ 2,200.
It is also a major success factor for any business that holds inventory because it helps a company control and forecast its earnings. For investors, inventory is an important item to analyze because it can provide insight into what’s happening with a company’s core business. However, the LIFO method may not represent the actual movement of inventory.
LIFO usually doesn’t match the physical movement of inventory because companies are more likely to try to move older inventory first. However, car dealerships or oil companies may try to sell items marked with the highest cost to reduce their taxable income. Assuming that prices are rising, this means that inventory levels are going to be highest because the most recent goods (often the most expensive) are being kept in inventory.
Below are the Ending Inventory Valuations:
In the tables below, we use the inventory of a fictitious beverage producer, ABC Bottling Company, to see how the valuation methods can affect the outcome of a company’s financial analysis. While U.S. generally accepted accounting principles allow both the LIFO and FIFO inventory method, the LIFO method is not permitted in countries that use the International Financial Reporting Standards (IFRS). Although the ABC Company example above is fairly straightforward, the subject of inventory—and whether to use LIFO or FIFO—can be complex. Knowing how to manage inventory is critical for all companies, no matter their size.
- The amount a company pays for raw materials, labor, and overhead costs is continually changing.
- By offsetting sales income with their highest purchase prices, they produce less taxable income on paper.
- Three of the four methods are included in the generally accepted accounting principles (GAAP) — standardized rules put in place to make sure companies don’t overstate their costs.
- When you account for inventory costs during a financial period, you need to compare the value of goods in inventory to your COGS.
Conversely, FIFO uses older costs in income, and LIFO does so for the balance sheet. The first unit was purchased earlier for $100; the second was purchased more recently at the current cost of $110. If both units remain unsold, the balance reported in Inventory (INV) would be $210 (100 + 110). Now assume that one unit is sold at a price of $132, consistent with a 20% markup of the current $110 cost.
If you’re based in the US but you sell internationally, you have to use FIFO, which at least makes the decision making process easier. As you can see, the COGS are attributed to the purchases made in August and September. As you can see, the COGS are attributed to the purchases made in July and August.
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 first in, first out (FIFO) method assumes that the first unit making its way into inventory–the oldest inventory–is sold first.
FIFO
The inventory costing method you choose can have a big impact on taxes as well as valuation. Note that all the numbers in this scenario are equal to 110% of what they were before the 10% price change. The LIFO inventory method results in all stakeholders having their share adjusted by the same amount—the change in price. If, however, an entity was forced to use FIFO, COGS would be $100, and pre-tax income would be $32. At the 30% tax rate, the tax bill would be $9.60 with after-tax earnings of $22.40. But the company would still need to replace the unit of inventory that was sold.
Using the example above, if you sell 500 ears of corn, the cost of goods sold is $1 per ear, or $500, and the cost of inventory on the books is $2 per ear, or $1,000. While LIFO produces a lower tax liability, the FIFO method tends to report a higher net income, which can make the company more attractive to shareholders. It also reports a higher value for current inventory, which can strengthen the company’s balance sheet. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method; once early inventory is booked, it may remain on the books untouched for long periods of time. Companies like retailers and auto dealerships use LIFO to manage large inventories. It helps reduce taxable income and increase cash flow when expenses rise.
