FIFO vs LIFO | Definitions, Differences and Examples
FIFO and LIFO are methods used in the cost of goods sold calculation. FIFO (“First-In, First-Out”) assumes that the oldest products in a company’s inventory have been sold first and goes by those production costs. The LIFO (“Last-In, First-Out”) method assumes that the most recent products in a company’s inventory have been sold first and uses those costs instead.
Here’s What We’ll Cover:
What Is the Difference Between FIFO and LIFO?
The method a company uses to assess their inventory costs will affect their profits. The amount of profits a company declares will directly affect their income taxes.
Inventory refers to purchased goods with the intention of reselling, or produced goods (including labor, material & manufacturing overhead costs).
FIFO and LIFO are assumptions only. The methods are not actually linked to the tracking of physical inventory, just inventory totals. This does mean a company using the FIFO method could be offloading more recently acquired inventory first, or vice-versa with LIFO. However, in order for the cost of goods sold (COGS) calculation to work, both methods have to assume inventory is being sold in their intended orders.
Which Method Is Better FIFO or LIFO?
FIFO is considered to be the more transparent and trusted method of calculating cost of goods sold, over LIFO. Here’s why.
By its very nature, the “First-In, First-Out” method is easier to understand and implement. Most businesses offload oldest products first anyway – since older inventory might become obsolete and lose value. As such, FIFO is just following that natural flow of inventory, meaning less chance of mistakes when it comes to bookkeeping.
LIFO allows a business to use the most recent inventory costs first. These costs are typically higher than what it cost previously to produce or acquire older inventory. As such, profits are lower. Although this may mean less tax for a company to pay under LIFO, it also means stated profits with FIFO are much more accurate because older inventory reflects the actual costs of that inventory. If profits are naturally high under FIFO, then the company becomes that much more attractive to investors.
The problem with a company switching to the LIFO method is that the older inventory may stay on the books forever, and that older inventory (if not perishable or obsolete) will not reflect current market values. It will be understated.
Lastly, under LIFO, financial statements are much more easier to manipulate.
It is considered a best practice to go with FIFO.
How Do You Calculate FIFO and LIFO?
To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.
To calculate COGS (Cost of Goods Sold) using the LIFO method, determine the cost of your most recent inventory. Multiply that cost by the amount of inventory sold.
Prices paid by a company for its inventory often fluctuate. These fluctuating costs must be taken into account regardless of which method a business uses.
Lastly, the product needs to have been sold to be used in the equation. A company cannot apply unsold inventory to the cost of goods calculation.
FIFO and LIFO Examples
We are going to use one company as an example to demonstrate calculating the cost of goods sold with both FIFO and LIFO methods.
Ted’s Televisions is a business in New York City. Ted has been in operation now for a year. This is what his inventory costs looks like:
Month Amount Price Paid
January 100 Units $800.00
February 100 Units $800.00
March 100 Units $825.00
April 100 Units $825.00
May 100 Units $825.00
June 100 Units $850.00
July 100 Units $850.00
August 150 Units $875.00
September 150 Units $875.00
October 150 Units $900.00
November 150 Units $900.00
December 150 Units $900.00
1450 units acquired.
Units = Televisions.
As you can see, the unit price of televisions steadily increased. Assuming Ted kept his sales prices the same (which he did, in order to stay competitive), this means there was less profit for Ted’s Televisions by the end of the year.
For the year, the number of televisions sold was 1100.
Let’s calculate cost of goods sold using the:
Going by the FIFO method, Ted needs to use the older costs of acquiring his inventory and work ahead from there.
So Ted’s COGS calculation is as follows:
200 units x $800 = $160,000
300 units x $825 = $247,500
200 units x $850 = $170,000
300 units x $875 = $262,500
100 units x $900 = $90,000
Ted’s cost of goods sold is $930,000.
Going by the LIFO method, Ted needs to go by his most recent inventory costs first and work backwards from there.
450 units x 900 = $405,000
300 units x 875 = $262,500
200 units x 850 = $170,000
150 units x $825 = $125,750
Ted’s cost of goods sold is $961,250.
You can see how for Ted, the LIFO method may be more attractive than FIFO. This is because the LIFO number reflects a higher inventory cost, meaning less profit and less taxes to pay at tax time.
The LIFO reserve in this example is $31,250. The LIFO reserve is the amount by which a company’s taxable income has been deferred, as compared to the FIFO method.
The remaining unsold 350 televisions will be accounted for in “inventory”.
Is LIFO Allowed Under GAAP?
Yes, LIFO is allowed under GAAP.
GAAP stands for “Generally Accepted Accounting Principles” and it sets the standard for accounting procedures in the United States. It was designed so that all businesses have the same set of rules to follow. GAPP sets standards for a wide array of topics, from assets and liabilities to foreign currency and financial statement presentation. Under GAAP, LIFO is legal.
Outside the United States, LIFO is not permitted as an accounting practice. This is why you’ll see some American companies use the LIFO method on their financial statements, and switch to FIFO for their international operations.
Most other countries are required to follow the rules set down by the IFRS (International Financial Reporting Standards) Foundation.