How you value your inventory makes a huge difference in how your business operates. You’ve probably heard of the FIFO vs. LIFO debate. It’s a battle as old as accounting itself. You may be wondering which of these two contenders is best for your business. Well, you’re in luck.
We’re breaking down the differences between these two inventory valuation methods and a host of other options. And we’re settling the FIFO vs. LIFO debate once and for all. But first, let’s start with the basics. What are inventory valuation methods, and why do they matter?
What Are Inventory Valuation Methods?
Inventory valuation methods are pretty self-explanatory. They are the way you choose to value your inventory. What makes them more complicated are the differences between methods and the fact that not one method is correct.
You should care about which method you use because it will determine how you calculate your cost of goods sold (COGS). FIFO vs. LIFO are two commonly used methods, so let’s start with the FIFO method and look at some similarities and differences.
What Is The FIFO Method?
FIFO stands for “first in, first out.” This method assumes that the first items entered into your inventory are the first you sell. Easy enough, right? Think of a grocery store. As new stock comes in, old stock gets pushed to the front to sell before it expires.
The FIFO method dictates that you sell older items before newer ones because each item’s value is tied to its age, newness, or freshness. In a grocery store, older items spoil or expire (losing their value), so they need to sell first to maximize profits and not waste inventory.
The FIFO method formula calculates the cost of goods sold by taking the cost of the oldest inventory and working forward until all products sold have been accounted for. Your FIFO ending inventory is then valued at the cost of your newest inventory.
Advantages Of Using The FIFO Method
- FIFO is good for perishable goods like cosmetics because it circulates items to sell by date.
- Most modern manufacturing businesses, food and beverage companies, and consumer packaged goods companies use FIFO.
- FIFO is internationally recognized and accepted. LIFO, on the other hand, is banned under International Financial Reporting Standards (IFSR) and is only accepted in the U.S. under Generally Accepted Accounting Principles (GAAP).
What Is The LIFO Method?
LIFO stands for “last in, first out.” It assumes that the last or most recent items entered into your inventory are the first to sell.
The LIFO inventory method means newer items sell first, while older items sit on warehouse shelves. The LIFO method is also only practiced in the U.S. and is illegal in the EU, Canada, Japan, Russia, and most other countries.
Advantages Of Using The LIFO Method
- If your industry deals with non-perishables or products with extended expirations such as retail, apparel, machinery, or some raw materials, LIFO may be a good fit.
- In the U.S., LIFO is sometimes used for tax purposes because of inflation. When prices rise, LIFO gives you the highest cost of goods sold with the lowest taxable income.
- Valuing your LIFO ending inventory is easier than FIFO because you use your most recent costs. That’s significant if you have lots of inventory turnover or frequent price fluctuations.
FIFO vs. LIFO: Which Is Better For Your Business?
Opting for FIFO or LIFO largely depends on your inventory flow, bookkeeping requirements, and tax affairs. FIFO and LIFO are basically opposites of each other, and FIFO is more commonly practiced. However, LIFO can have tax advantages depending on your industry.
Bookkeeping Requirements
LIFO bookkeeping is usually more of a pain than FIFO bookkeeping. There’s no way around it.
That’s because using LIFO, older inventory can be held for long periods, so the inventory becomes “layered.”
FIFO bookkeeping assumes older inventory gets swapped out quickly and regularly, so it’s generally more straightforward to track in your books.
If bookkeeping is a top priority for your business, and you’re willing to lose some net income and pay more in taxes to make things easier, FIFO may beat LIFO here. However, tax implications are where LIFO becomes a dark horse candidate.
Tax Implications
LIFO inventory valuation is permitted by the IRS and by Generally Accepted Accounting Principles (GAAP). If you’re doing business in only the U.S., you’re good.
LIFO is not permitted under international financial reporting standards (IFRS)—something to be aware of if you do business internationally.
If you opt to use LIFO over FIFO, you need to file Form 970 with the IRS. You will have the option to value your entire inventory using LIFO, or use LIFO just to value certain items you carry.
However, once you choose LIFO, you cannot switch back to FIFO or another inventory valuation method without first getting IRS approval. If you wish to request a change in inventory valuation method, you must file Form 3115, Schedule D, Part 2.
Inventory Flow Preferences
Most businesses sell the oldest items in stock first. That’s why a lot of manufacturing companies choose FIFO.
If your stock loses its value over time, like a brick-and-mortar grocery store, chances are you are pushing older items to sell faster before they expire and lose their value. FIFO is better in those instances.
Depending on your industry, however, new inventory might get sold first. Usually, this only happens if your product’s value isn’t tied to its age.
Timber, concrete, and gravel, for example, are not rotated when new supply arrives, and it doesn’t matter if gravel is a day old, a week old, or a month old when it sells. Gravel doesn’t have an expiration date.
In these instances, newer inventory can sell first without there being a problem. If your industry deals with non-perishables, LIFO inventory calculation might make more sense than FIFO.
Other Inventory Valuation Methods To Consider
Specific Cost Method
- The specific cost method is a valuation method that ties cost to specific inventory items, normally using a serial number or some other unique identifier.
Weighted Average or Average Cost Method
- The weighted average method, or average cost method, calculates the cost by dividing the total cost of goods purchased or produced by the quantity of units purchased or produced.
- A weighted average is often taken when inventory is non-perishable but stock can easily be swapped or mixed together.
Retail Method
- Under the retail method, the value of inventory is calculated based on the retail price of the inventory reduced by the markup percentage rather than by the cost to obtain it. This method is the most vague/least specific inventory valuation method.
Gross Profit Method
The gross profit, or gross margin, method calculates gross profit by subtracting the total cost of goods sold (COGS) from your total revenue.
What Inventory Valuation Method Is The Best?
Ultimately, FIFO vs. LIFO may come down to tax implications for your business and the shelf life of your product. Taxes shouldn’t be the only factor you consider, though.
FIFO is the most common and trusted method of inventory valuation. That being said, LIFO is better in certain cases depending on the product you sell and where you sell it.
Understanding your tax requirements, inventory flow, and bookkeeping requirements should help you make an informed decision about the right inventory valuation method for your business.
Have more questions about FIFO vs. LIFO inventory valuation for your business? Contact our experts to learn about what’s right for you.
