FIFO vs LIFO: Comparing Inventory Valuation Methods

When businesses assess the value of their inventory and their cost of goods sold, they typically use one of two common valuation methods: FIFO or LIFO. FIFO, or First In, First Out, assumes that businesses sell their oldest goods first. LIFO, or Last In, First Out, assumes that businesses sell their most recently purchased goods before anything else.

Although a business’s real income and profits are the same, using FIFO or LIFO will result in different reported net income and profits. This also has implications for their tax liabilities.

We’ll explore the differences between FIFO and LIFO inventory valuation methods and their relationship to inventory valuation, inflation, reporting, and taxes. We’ll also examine their advantages and disadvantages to help you find the best fit for your small business.

Key Takeaways

• FIFO and LIFO are accounting methods used to assign value to inventory.
• FIFO stands for First In, First Out and assumes older products are sold first.
• LIFO stands for Last In, First Out and assumes that the most recently purchased products are sold first.
• FIFO and LIFO have different implications for inventory valuation, financial reporting, and taxes.

Table of Contents

• Understanding The FIFO And LIFO Method
• LIFO vs FIFO: Inventory Valuation
• LIFO vs FIFO: Inflation’s Influence
• LIFO vs FIFO: Financial Reporting
• LIFO and FIFO: Taxes
• FIFO vs LIFO Advantages And Disadvantages
• How To Calculate FIFO and LIFO
• FIFO vs LIFO Example
• Difference Between FIFO and LIFO
• Which Method Is Better: FIFO or LIFO?
• Final Thoughts: Evaluating LIFO and FIFO

Understanding The FIFO and LIFO Method

When businesses hold inventory, they’re required to assign a value to the products they’ve sold and to the products that remain in their warehouse. There are two important components to inventory: cost of goods sold and remaining inventory.

Cost of Goods Sold, or COGS, is the amount of money a business pays to produce the number of goods sold in a given period. The products that are left in the warehouse are called remaining inventory.

Different inventory valuation methods will have different effects on COGS and remaining inventory values. Two common methods for inventory valuation are called FIFO and LIFO:

FIFO Method

FIFO, or First In, First Out, assumes that a company sells the oldest inventory first. Therefore the first batch of inventory that they order is also the first to be disposed of, leading to a steady inventory turnover. 

Since the cost of labor and materials is always changing, FIFO is an effective method for ensuring current inventory reflects market value. Older products are assumed to have been purchased at a lower cost, so when they’re sold first the remaining inventory is closer to the current market price.

LIFO Method

LIFO, or Last In, First Out, assumes that a business sells its newest inventory first. This is the opposite of the FIFO method and can result in old inventory staying in a warehouse indefinitely.

Under LIFO, remaining inventory may not be a reflection of market value. This is because older inventory was often purchased at a lower price and the market may have changed since the early orders.

LIFO vs. FIFO: Inventory Valuation

FIFO and LIFO have different impacts on inventory management and inventory valuation. In most cases, businesses will choose an inventory valuation method that matches their real inventory flow. Thus, businesses that choose FIFO will try to sell their oldest products first. 

The type of inventory that a business holds can influence its choice of FIFO or LIFO. For example, businesses with a beginning inventory of perishable goods will usually choose FIFO, since it’s in their best interest to sell older products before they expire. Using the appropriate inventory valuation system can help track real inventory management practices.

FIFO and LIFO also have different impacts on inventory value and financial statements. Under FIFO, older (and therefore usually cheaper) goods are sold first, leading to a lower average cost of goods sold. This means that a company reports a higher gross income. In contrast, LIFO results in higher COGS and lower reported gross income.

Since FIFO sells cheaper goods first, the remaining inventory holds a higher value. Under LIFO, the remaining inventory value is lower, since the older and cheaper goods are left in the warehouse and only sold after the new products.

LIFO vs. FIFO: Inflation’s Influence

FIFO and LIFO have different impacts on inventory valuation and financial statements as a result of inflation. In a normal inflationary economy, prices of materials and labor steadily rise. Thus, goods purchased earlier were normally bought at a lower cost than goods purchased later. 

This means that ‘first in’ inventory has a lower cost value than ‘last in’ inventory. Even if a company produces only one product, that product will have different cost values depending upon when they produce it. When inventory is acquired and when it’s sold have different impacts on inventory value. 

Higher inflation rates will increase the difference between the FIFO and LIFO methods since prices will change more rapidly. If inflation is high, products purchased in July may be significantly cheaper than products purchased in September. Under FIFO, we assume all of the July products are sold first, leaving a high-value remaining inventory. Under LIFO, September products are sold first even if July products are left over, leaving the remaining at a low value.

LIFO vs. FIFO: Financial Reporting

In addition to impacting how businesses assign value to their remaining inventory, FIFO and LIFO have implications for other aspects of financial reporting. Some key elements include income statements, gross profit, and reporting compliance.

Gross income is calculated by subtracting the cost of goods sold from a company’s revenue for a given period. Therefore, when COGS is lower (as it is under FIFO), a company will report a higher gross income statement. 

Higher reported gross income also leads to an inflated representation of profits. A company generates the same amount of income and profits regardless of whether they use FIFO or LIFO, but the different valuation methods lead to different numbers on the books. This can make it appear that a company is generating higher profits under FIFO than if it used LIFO.

FIFO is also generally considered to be a more accurate and reliable inventory valuation method since it is more difficult to misrepresent costs. As such, FIFO is a generally accepted accounting principle in almost all jurisdictions, whereas LIFO accounting is only accepted in some. It’s important to check industry standards in your jurisdiction to ensure your valuation method meets regulatory compliance.

LIFO and FIFO: Taxes

Cost of goods sold is an expense for a business, meaning it will also have tax implications. Under FIFO, COGS is lower and gross income is higher. This produces a higher taxable income, so a business will typically have to pay more in taxes.

In contrast, the LIFO inventory valuation method results in a higher COGS so the company can claim a greater expense. This produces a lower taxable income and therefore a lower tax bill.

The rate of inflation impacts the size of the tax differential created by FIFO and LIFO. Under a high-inflation economy, using FIFO results in a significantly lower COGS, leading to a higher taxable income and tax bill. Therefore, inflation rates may impact a business’s choice to use either FIFO or LIFO.

FIFO vs. LIFO Advantages and Disadvantages

The most significant difference between FIFO and LIFO is its impact on reported income and profits. In most cases, these are seen as an advantage and disadvantage. For FIFO, higher gross income and profits may look more appealing to investors, but it will also result in a higher tax bill. Under LIFO, lower reported income makes the business look less successful on paper, but it also has a lower tax liability.

FIFO also has the advantage of being a straightforward system. This makes it easy for business owners to manage their accounting and makes it simple for investors to interpret the financial statements. FIFO is an accepted method under International Financial Reporting Standards.

Finally, FIFO encourages a regular inventory turnover as older stock is sold off first. However, if inventory remains stagnant for a few years, there can be a significant discrepancy between cost of goods sold and market value when sales resume.

FIFO	LIFO
Pro: encourages regular inventory turnover	Pro: lower reported income results in lower tax bill
Pro: reporting higher gross income and profits can be appealing to investors	Pro: allows companies to claim greater expenses
Pro: more accurately reflects the current market value of inventory	Pro: can make it easier to access recent and popular inventory items
Con: higher reported income results in a higher tax bill	Con: may not be accurate to the real flow of inventory
Con: can be problematic for businesses with stagnant inventory	Con: not regulatory compliant in all jurisdictions

How To Calculate FIFO and LIFO

To calculate FIFO and LIFO, follow the same basic formula:

Cost of Goods Sold = Purchase Price of Goods x Number of Goods Sold

Under FIFO, the purchase price of the goods begins with the price of the earliest goods purchased. If you sold more than that batch, you repeat the formula with the next earliest batch.

With LIFO, the purchase price begins with the most recently purchased goods and works backward. 

In both cases, only goods actually sold are included in the calculations. This means that if you purchased a batch of 300 goods and only sold 150, you would multiply the purchase price by 150. The leftover goods are accounted for in the remaining inventory.

FIFO vs. LIFO Example

We’ll use an example to show how FIFO and LIFO produce different inventory valuations for the same business.

Company A sells vacuums. The following shows their inventory purchases for the first quarter:

Month, Unit Amount, Price per Unit

January, 50, $200

February, 100, $220

March, 100, $240

Despite increasing production costs, Company A retains a consistent sales price of $400 per vacuum. They sell 200 vacuums in the first quarter, generating a revenue of $80,000.

FIFO Method

Under FIFO, we assume that company A sold the $200 vacuums first, followed by the $220 vacuums, then the $240 vacuums. We can use the formula:

Cost of Goods Sold = Purchase Price of Goods x Number of Goods Sold

Cost of Goods Sold = ($200 x 50) + ($220 x 100) + ($240 x 50).

Cost of Goods Sold = $10,000 + $22,000 + $12,000

Cost of Goods Sold = $44,000

Company A only sold 200 vacuums, leaving 50 of the March vacuum order left in inventory. Their remaining inventory would then be $240 x 50 = $12,000

Gross profits are calculated by subtracting COGS from revenue, so Company A’s gross profits for this quarter are $80,000 – $44,000 = $36,000.

LIFO Method

Under LIFO, Company A sells the $240 vacuums first, followed by the $220 vacuums then the $200 vacuums. 

Cost of Goods Sold = Purchase Price of Goods x Number of Goods Sold

Cost of Goods Sold = ($240 x 100) + ($220 x 100) 

Cost of Goods Sold = $24,000 + $22,000

Cost of Goods Sold = $46,000

This leaves 50 of the $200 January vacuums left in inventory. Their remaining inventory would then be $200 x 50 = $10,000

This gives Company A a gross profit of $80,000 – $46,000 = $34,000.

Difference Between FIFO and LIFO

The following table highlights the major differences between the FIFO and LIFO methods of inventory valuation: 

	FIFO	LIFO
Complexity	Simple and straightforward	More complex
COGS	Lower COGS	Higher COGS
Reported Profits	Higher gross income and profits	Lower gross income and profits
Tax Liability	Higher tax bill	Lower tax bill
Regulatory Compliance	Widely accepted	Not accepted in all jurisdictions

Which Method Is Better: FIFO or LIFO?

FIFO is generally accepted as the more accurate inventory valuation system. Regular inventory turnover tends to keep inventory value closer to market value and is a more realistic representation of how most companies move their products.

FIFO is also more straightforward to use and more difficult to manipulate, making it more popular as a financial tool. FIFO is also the best fit for businesses like food producers or fashion retailers who hold inventory that is perishable or dependent on trends.

Final Thoughts: Evaluating LIFO and FIFO

FIFO and LIFO are two common methods businesses use to assign value to their inventory. They’re important for calculating the cost of goods sold, the value of remaining inventory, and how those impact gross income, profits, and tax liability.

The right accounting software helps you track your inventory values so you can quickly and easily calculate costs. FreshBooks accounting software lets you organize inventory costs, keep track of shipments, and organize invoices so you can stay on top of vendor payments. Try FreshBooks free to discover how streamlining your inventory process can help you grow your small business today.

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