Hello again readers! Today I am going to tell you the tale of LIFO and FIFO. Now, before you get too excited we are talking about inventory methods, not Hobbits or Elves. Do I still have any readers left? Good, we shall continue then.
LIFO stands for Last In, First Out and FIFO stands for First In, First Out, simple enough right? Before we dive further into LIFO and FIFO, we must first understand what exactly inventory is. Inventory is, in it simplest form, assets that are meant to be for sale. Below is a formula that is commonly used to determine inventory.
Start of Inventory + Purchases – Cost of Goods Sold (COGS) = Ending Inventory
Meaning add the inventory you start with to new inventory you purchase, subtract the inventory you sold, and your current inventory is what remains. Still following?
So now that we have inventory figured out we can get into how we value inventory, and the inventory-costing methods used by most companies. These methods directly affect the balance sheet, and they are…you guessed it, LIFO and FIFO.
FIFO (First In, First Out)
This inventory method is where the first unit coming into inventory is the first unit sold. Let’s try this with an example. A company called Fun Factory produces widgets, in fact they make the best widgets in the world, not really part of the example but I just wanted to make sure you know. In January it cost the Fun Factory $200 to make 10 widgets, but in February, because of a rise in cost of thingamajigs, which everyone knows are vital to make widgets, it costs Fun Factory $250 to make 10 widgets. The FIFO method would show that if Fun Factory sold 10 widgets in March, the Cost of Goods Sold (COGS) is $200 per widget because that was the cost at the time when the first widgets went into inventory.
LIFO (Last In, First Out)
Now for this inventory method the last unit coming into inventory is the fist unit sold. So for the 10 widgets sold in March, Fun Factory would assign $250 per widget to the COGS, while the remaining $200 widgets are used to calculate the value of inventory.
So now we know the difference, but what is the best one to use? That depends on what kind of goods you have. FIFO is simpler to report on taxes and makes the company look better to investors as it increases the amount of income. FIFO inventory is considered to be a more accurate inventory report. LIFO is used by companies that want to reduce taxable income or companies that sell products where the cost of the items are increasing, such as oil companies. LIFO inventory has become more popular since the 1970’s as it reduces income tax in times of inflation; LIFO is only used in theUS and Japan.