FIFO vs LIFO: How to Pick an Inventory Valuation Method

In the retail sector, LIFO is a common method for valuing inventory, especially during periods of inflation. Imagine a clothing retailer that frequently restocks its shelves with new merchandise. As prices for clothing materials and manufacturing increase accounting software over time, the retailer may choose to use LIFO to match the latest inventory costs with revenue. By assuming that the most recently acquired items are the first to be sold, the retailer can reflect the current market prices more accurately.

FIFO vs LIFO: Comparing Inventory Valuation Methods

We believe everyone should be able to make financial decisions with confidence. Even if you’ve been using one or the other for years, you can always change methods, though you should seek the guidance of a CPA during this somewhat complicated process. Another difference is that FIFO can be utilized for both U.S.- and internationally based financial statements, whereas LIFO cannot. According to Ng, much of the process is the same as it is for FIFO, including this basic formula.

What Is The LIFO Method? Definition & Examples

In addition, there is the risk that the earnings of a company that is being liquidated can be artificially inflated by the use of LIFO accounting in previous years. Last in, first out (LIFO) is a method used to account for business inventory that records the most recently produced items in a series as the ones that are sold first. To determine the cost of units sold, under LIFO accounting, you start with the assumption that you have sold the most recent (last items) produced first and work backward. Many businesses find this requirement alone negates any benefits of LIFO valuation. However, you also don’t want to pay more in taxes than is absolutely necessary.

LIFO, Inflation, and Net Income

They sell 200 vacuums in the first quarter, generating a revenue of $80,000. 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. This is because older inventory was often purchased at a lower price and the market may have changed since the early orders. Although a business’s real income and profits are the same, using FIFO or LIFO will result in different reported net income and profits.

• The LIFO method, which applies valuation to a firm’s inventory, involves charging the materials used in a job or process at the price of the last units purchased.
• The older inventory, therefore, is left over at the end of the accounting period.
• Some of the more important problems include the effects of prices, LIFO liquidation, purchase behavior, and inventory turnover.
• Under inflationary economics, this translates to LIFO using more expensive goods first and FIFO using the least expensive goods first.

While businesses can switch between LIFO and FIFO, the decision requires careful consideration and may have implications for financial reporting, tax obligations, and inventory management practices. It’s advisable to consult with accounting professionals before making such a change. Imagine you own a toy store, and you recently purchased 50 units of a popular action figure at $10 each.

Inventory valuation for tax purposes

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. If we apply the periodic method, we will not concern ourselves with when purchases and sales occur during the period. We will simply assume that the earliest units acquired by the shop are still in inventory. The earliest unit is the single unit in the opening inventory and therefore the remaining two units will be assumed to be from the current month’s purchase. For example, the inventory balance on January 3 shows one unit of $500 that was purchased first at the top, and the remaining 22 units costing $600 each that were later acquired shown separately below.

In this lesson, I explain the easiest way to calculate inventory value using the LIFO Method based on both periodic and perpetual systems. In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. Therefore, by making purchases at year-end, the cost of any purchase will be included in the cost of goods sold.

For example, if the replacement cost of a business’s inventory exceeds its LIFO value, a business risks undervaluing its inventory when filing small business taxes. There are a number of factors that impact which inventory valuation method you should use. Tax considerations play a large role in your choice, but tax impact shouldn’t be the only thing you consider when choosing between FIFO and LIFO. Let’s say you own a craft supply store specializing in materials for beading. Your inventory doesn’t expire before it’s sold, and so you could use either the FIFO or LIFO method of inventory valuation. In general, both U.S. and international standards are moving away from LIFO.

In effect, a firm is apt to sell units that may have 2000 or 2010 costs attached to them. The result is a lower cost of goods sold, higher gross margin, and higher taxes. LIFO liquidation occurs when a firm sells more units than it purchases in any year. Thus, LIFO layers that have been built up in the past are liquidated (i.e., included in the cost of goods sold for the current period). Last in, First Out (LIFO) is an inventory costing method that assumes the costs of the most recent purchases are the costs of the first item sold. One downside to using the LIFO method is that older inventory may continue to sit in the warehouse unless the business sells all of its newer inventory.