FIFO and LIFO are two inventory-tracking methods used to calculate the cost of goods sold. FIFO (first in, first out) assumes that the oldest inventory units received were sold first. For most companies, it’s the easiest way to track inventory. In contrast, LIFO (last in, first out) supposes the most recent inventory units have been sold first. But beyond the definitions, what are the differences between these two methods? And when you’re managing your inventory, how do you choose between LIFO and FIFO?
FIFO and LIFO in inventory accounting
If your business sells products, then you need a way to track your goods. A strong inventory management system tells you how much of a particular item remains in stock and which items need to be reordered. But in addition, you need to know how much inventory your business is selling, for your own recordkeeping and for tax purposes.
You also need to know how much it costs your business to produce those goods. This calculation is commonly referred to as the cost of goods sold (COGS). COGS is listed on a company’s balance sheet and is subtracted when determining gross income.
Investors often look at this metric when deciding whether to invest in a company. A high COGS can be a red flag, since it means less profit over time.
Use this formula to calculate COGS:
Starting inventory + Purchases – Ending inventory = Cost of goods sold
That’s where FIFO And LIFO come into play. Both methods help you track how much inventory you have and the costs that go into creating those products.
FIFO vs. LIFO
Here is an overview of the main differences between FIFO and LIFO:
|Stands for “first in, first out”||Stands for “last in, first out”|
|Assumes the first inventory received is the first to go||Assumes the last inventory received is the first to go|
|The most common inventory-tracking method||More common for perishable goods or when the price of inventory frequently changes|
|Leads to fewer errors and lost income||Can help companies limit taxable income|
|Can lead to a higher tax rate||Isn’t always a natural way to track inventory|
FIFO stands for “first in, first out,” and it assumes the oldest inventory items are the first to go. This supposition holds true whether you’re running an e-commerce website or a brick-and-mortar business. All products leave your warehouse in the order they arrive.
FIFO is the most common inventory-tracking method. It often leads to fewer errors and less money lost on your inventory. FIFO also accounts for inflation and reduces fluctuation. However, if you earn a larger profit using FIFO, you may also have to pay higher taxes.
LIFO stands for “last in, first out” and assumes the last inventory items received will be the first to go. LIFO is the opposite of FIFO. It’s a good method to use if the price of inventory is constantly changing or if you order perishable goods.
LIFO is helpful for companies looking to keep their costs down. But it’s not a natural way to track inventory, and it works against the way many people envision products moving through their business.
Which should you choose: FIFO or LIFO?
There is no right or wrong choice when it comes to tracking inventory, but certain methods may be better for your business. Here are a few factors to consider when evaluating FIFO vs. LIFO.
- The type of inventory you sell: The inventory-tracking method you should use largely depends on the products you offer. For instance, most businesses sell the oldest items in stock first. But some companies don’t rotate their inventory, and the newest items are sold first.
- Taxes: If you have a higher COGS, you’ll see a lower net profit and higher taxes. High inventory costs mean you’ll have a lower tax burden.
- Your recordkeeping methods: If you track inventory using the LIFO method, you’ll have more recordkeeping requirements and will need to keep these files for several years. FIFO comes with fewer recordkeeping demands, since the oldest items are sold first. FIFO is also a more natural way to track inventory.
- Whether costs are on the rise: LIFO may be a better choice if inventory costs are going up, since the higher-cost items will be sold first. But if inventory costs are going down, FIFO may be the better option.
- Reporting requirements: FIFO and LIFO are allowed by the IRS and can be used under the Generally Accepted Accounting Principles (GAAP), but LIFO is not permitted under the International Financial Reporting Standards (IFRS). If you plan to do business internationally, LIFO isn’t an option.
Bottom line: FIFO is the default accounting standard and the easiest way to track inventory. But if you’re looking to lower your taxable income, LIFO may be the right accounting method for your business.
How to calculate FIFO and LIFO
Since FIFO assumes the first items purchased are the first ones sold, you’ll start by looking at the earliest items purchased during that reporting period. Once you’ve determined the cost of your oldest inventory, multiply that number by the total amount of inventory sold.
The LIFO method supposes that the most recent items purchased will be the first ones sold, so you’ll start by looking at the most recent inventory. This means the ending value of your inventory is determined by the cost of the oldest items.
The price of inventory can fluctuate, and you must account for those costs, regardless of whether you use FIFO or LIFO. Businesses cannot calculate the COGS for unsold inventory.
Example of FIFO vs. LIFO
The inventory-tracking methods a business uses can have a significant impact on its financial statements. To understand the difference between FIFO and LIFO, let’s look at a fictional inventory example.
ABC Corporation sells T-shirts, and inventory costs have soared over the past few months. Here is an overview of its stock during the fourth quarter:
|Inventory||Quantity purchased||Purchase price|
At the end of the year, the company wants to calculate the cost of goods sold using the FIFO method. The company has sold 120 T-shirts so far.
Since the company is using FIFO, it’ll use the oldest calculation of $6 per shirt. It would use this equation to calculate the COGS:
120 x 6 = $720
If the company wanted to calculate COGS using LIFO, it would use the most recent cost of $10 per shirt. Here is the calculation it would use for COGS:
120 x 10 = $1,200
With FIFO, the company’s profits are higher, but that means it’ll also have more taxable income. Under LIFO, the company will pay fewer taxes, but the lower profits could hurt it if it ever looks for an outside investor.
Taxes and accounting rules for FIFO and LIFO
Under GAAP standards, both FIFO and LIFO are acceptable inventory-tracking methods. If your business wants to defer taxes in an inflationary environment, then LIFO is an appealing choice.
However, many tax professionals don’t recommend using LIFO. For one thing, FIFO is the default accounting method, and it’s easier. The IRS doesn’t like LIFO, since it results in less taxable income. In addition, LIFO is not allowed under the IFRS, so you can’t use it if you’re doing business internationally.
If you do want to use LIFO, apply to use this method with Form 970.
FYI: While GAAP lets companies use either FIFO or LIFO, it doesn’t allow them to switch back and forth between the two methods. If you decide to track your inventory with the LIFO method, you can’t switch to FIFO unless you receive permission from the IRS. If you need to change your financial accounting methods, you should use Form 3115 to apply.
The bottom line on FIFO vs. LIFO
FIFO and LIFO are two ways to track COGS. FIFO is more straightforward, and it follows the natural flow of inventory. However, LIFO is appealing for businesses that want to keep their taxes low.
Whichever method you choose, make sure you’re complying with IRS regulations and GAAP standards. If you’re having a hard time deciding between LIFO and FIFO, an accountant can recommend the right choice for your business.