FIFO Vs. LIFO AccountingMarch 24, 2021
For businesses like ecommerce stores that need to maintain an inventory, the manner in which they calculate their cost of goods sold can have a significant impact on their taxes and profitability.
There are two methods businesses typically use to calculate the cost of goods sold: FIFO and LIFO. Read on to find out what these methods are, how they differ, and the reasons why businesses might prefer one over the other.
The Difference Between FIFO and LIFO
The method chosen to assess inventory costs will directly impact reported profits. Why? Because FIFO and LIFO both track inventory totals in a different order.
The FIFO (First-In, First-Out) method assumes that the oldest products in a company’s inventory are the first items to be sold. On the other hand, the LIFO (Last-In, First-Out) method assumes the most recent items in a company’s inventory are the first to be sold.
Is It Better To Use FIFO or LIFO?
Neither method is better or worse than the other. Instead, it depends on how a business’s costs are changing throughout the year.
LIFO is better when your inventory costs are going up or are likely to increase as you progress into the year. This is because the most recent, higher cost items are considered to be sold, which results in higher costs and lower profits. In this case, using LIFO will reduce your business’ taxable income.
If instead, your inventory costs are going down, it might be better to use FIFO as the more expensive products you sold earlier in the year are accounted for. However, since prices usually increase, many businesses prefer to use LIFO.
How Are FIFO and LIFO Calculated?
The FIFO and LIFO formulas for calculating the Cost of Goods Sold (COGS) are as follows:
FIFO COGS = The cost of your oldest inventory multiplied by the amount of inventory sold.
LIFO COGS = The cost of your most recent inventory multiplied by the amount of inventory sold.
FIFO and LIFO Examples
We’ll use one business as an example to show how the cost of goods sold is determined using both FIFO and LIFO methods.
Johnny’s Smartphones is a company that has been in business for a year. Here’s what their inventory costs are:
850 units purchased.
Units = Smartphones
Over the year, the unit price of these cellphones increased steadily. If Johnny’s Smartphones kept their prices the same, this means there was less profit for them by the end of the year.
For the year, the number of smartphones sold was 500.
Using the FIFO and LIFO method, we’ll calculate the cost of goods sold.
Using the FIFO method, Johnny’s Smartphones need to use the older costs of acquiring their inventory and work ahead from there.
Here is Johnny’s Smartphones COGS calculation:
100 units x $50 = $5,000
150 units x $75 = $11,250
250 units x $100 = $25,000
Johnny’s Smartphones cost of goods sold is $41,250.
With the LIFO method, Johnny’s Smartphones need to use their most recent inventory costs and work backward from there:
300 units x $125 = $37,500
200 units x $100 = $20,000
Johnny’s Smartphones cost of goods sold is $57,500.
For some businesses, the calculation above is the reason why the LIFO method is more appealing. This is because the LIFO number usually reflects a higher cost of inventory, which means there is less profit and less taxable income as a result.
Accounting Standards And LIFO
LIFO is allowed under the United States’ Generally Accepted Accounting Principles. However, outside the United States, LIFO is not permitted as an accounting practice. That’s why many American companies who use LIFO switch to using FIFO for their international operations.
When it comes to choosing between FIFO and LIFO accounting, there is no right or wrong answer. It all depends on how your business’ costs are changing throughout the year and the impact choosing either FIFO or LIFO will have on your taxes and reported profits.