Difference Between FIFO and LIFO
FIFO and LIFO are two common inventory valuation methods used in accounting. FIFO stands for First-In, First-Out, while LIFO stands for Last-In, First-Out. They differ in how they calculate the cost of goods sold (COGS) and the value of remaining inventory.
- FIFO (First-In, First-Out): Under FIFO, it is assumed that the first goods purchased or produced (the oldest inventory) are the first to be sold, and the last goods purchased or produced (the newest inventory) remain in inventory. When prices are rising, FIFO will result in a lower COGS and a higher inventory value compared to LIFO, which can lead to higher taxable income.
- LIFO (Last-In, First-Out): Under LIFO, it is assumed that the last goods purchased or produced (the newest inventory) are the first to be sold, and the first goods purchased or produced (the oldest inventory) remain in inventory. When prices are rising, LIFO will result in a higher COGS and a lower inventory value compared to FIFO, which can lead to lower taxable income.
Here’s a simple example:
Imagine a company buys 100 units of a product for $10 each in January and 100 more units of the same product for $15 each in February. If the company sells 100 units in March:
- Under FIFO, the COGS will be $10 * 100 = $1,000 because the first units bought are the first to be sold.
- Under LIFO, the COGS will be $15 * 100 = $1,500 because the last units bought are the first to be sold.
As you can see, the choice of inventory valuation method can significantly impact the reported profit, tax liabilities, and the valuation of inventory on the balance sheet. It’s important to note that the method chosen should be used consistently from one accounting period to another to ensure accurate financial reporting.
Example of the Difference Between FIFO and LIFO
Let’s take a toy manufacturing company as an example.
Scenario:
This company purchases raw materials for its toys three times over the year:
- In January, the company buys 100 units of materials for $10 each, spending $1,000 in total.
- In June, it purchases another 100 units for $15 each, spending $1,500.
- In October, it buys yet another 100 units, but this time for $20 each, spending $2,000.
By the end of the year, the company has made and sold 200 toys.
FIFO Example:
Under the FIFO (First-In, First-Out) method, the cost of goods sold (COGS) assumes that the first units of materials purchased (those bought in January and June) were used first. So, the COGS would be:
- First 100 units sold from January’s inventory: 100 units * $10/unit = $1,000
- Next 100 units sold from June’s inventory: 100 units * $15/unit = $1,500
So, the total COGS using FIFO is $1,000 (January) + $1,500 (June) = $2,500
The remaining inventory would be from the October purchase: 100 units * $20/unit = $2,000.
LIFO Example:
Under the LIFO (Last-In, First-Out) method, the COGS assumes that the last units of materials purchased (those bought in October and June) were used first. So, the COGS would be:
- First 100 units sold from October’s inventory: 100 units * $20/unit = $2,000
- Next 100 units sold from June’s inventory: 100 units * $15/unit = $1,500
So, the total COGS using LIFO is $2,000 (October) + $1,500 (June) = $3,500
The remaining inventory would be from the January purchase: 100 units * $10/unit = $1,000.
As you can see, FIFO and LIFO give you different results for COGS and remaining inventory. These differences can significantly impact reported profitability and tax liability, depending on the trends in prices.
