FIFO vs LIFO: The Disadvantages and Advantages to Inventory Valuation
Managing a business can be difficult. You’ve got employees to hire, operations to oversee, accounting to handle and customers to please. Probably the most intimidating of these to take care of is the accounting aspect as it’s a bunch of numbers, reports, and methods to understand. Accounting is also easily the most important sector because without it you’ll never know how much money you’re making, how much you’re spending or how to price your services or products.
With our Managerial Accounting course, you can build a solid foundation of financial standards and accounting methods to implement at your business. When you price an item you want to ensure that it’s comparable to going market rates while still making a profit. The cost of goods is the price you pay to obtain your inventory and when the cost of goods is low and the market value high – you’ll enjoy a nice profit margin. Likewise, the contrary can be true.
What is cost accounting?
Cost accounting is a branch of accounting that deals with the company’s financial information and the people who make the decisions. This is why cost accounting is also referred to as managerial accounting. The information obtained in this sector of accounting is used to create management plans and manage inventory cost, or material flow cost. There are two techniques of inventory valuation: first in last out (FIFO) and last in first out (LIFO). For more about cost classification, cost behavior and cost coding check out an Introduction to Bookkeeping.
The first in first out method of inventory management explains the order in which inventory is purchased and then sold. When a business utilizes the FIFO method, they sell the products that they received first before selling the products they received last. FIFO is the most popular method of inventory management as it’s easier to use than it’s last in first out counterpart and it’s more practical – especially when regarding perishable goods.
For example, when you go grocery shopping you may notice that perishable goods, like milk, have expiration or sell by dates on them. All grocery stores apply the FIFO inventory management method to overseeing their goods. Because of this, you’ll notice that the milk in the front of the shelf will have an earlier expiration date than the milk on the back of the shelf. This happens because the milk with the earlier expiration date was bought by the grocery store earlier than the milk behind it with the later dates. Hence, the goods first in, or bought, by the grocery store are the first out. It would be impractical to try and sell the newly received milk before the older received milk as the first bought milk supply could expire and the milk would be spoiled. Then the inventory manager would have to record the loss and the store would lose money.
Although the FIFO method is most definitely the best way to go for grocery stores and other stores that sell perishable goods – they aren’t the only stores who use FIFO. So why would other stores use this method? In the course Accounting in 60 Minutes you can learn more about inventory flow and management accounting.
1. When a company uses FIFO they are less likely to incur old and outdated inventory that can no longer be sold. Accountants have to write off what’s called obsolete inventory after a certain amount of time goes by and the product is not used or sold. Because FIFO makes sure that the oldest items in stock are used or sold before they are deemed obsolete companies can save money.
2. Inflation happens, actually it’s pretty constantly happening. Let’s say you purchase a batch of dog food in May for $4,000. Come June when you are going to purchase another batch for your inventory, the prices have risen to over $6,000. Using FIFO, you would be selling off the batch from May before you sell off the batch from June, right? So now you can sell the batch from May for the current inflated market price which reduces the impact of inflation on the company.
3. With cost accounting comes a lot of financial recording. When companies use FIFO they will constantly have an updated reflection of the current market prices for the items in their inventory. This happens as older products are taken from the inventory stock to be sold, the newer inventory is left on the books for the end of the month. This way, your balance sheet is always showing current market prices.
4. It is the most widely accepted way for inventory management.
With the advantages do come some disadvantages. However, even these disadvantages beat the advantages of using the LIFO method. We’ll get to that shortly.
1. I think one of the biggest disadvantages to FIFO is the inconsistent prices given to clients. For example, if you’re buying that same batch of dog food for $4,000 and the next month you have to spend $6,000, you’re obviously going to have to increase your asking price a bit or your profit margin shrinks. Repeat clients may find this challenging at times but they should also understand the ebb and flow of the market.
2. The second disadvantage would be clerical errors. When inventory prices are always in flux it can become cumbersome to correctly record cost of goods, selling price of goods and any discrepancy that may occur because of rising or falling market prices. With last in first out, the last batch of goods purchased is the first batch of goods being sold so the likelihood of a price change is low. However, LIFO has many cost layers and can become quite confusing to record correctly. There is more to this but see LIFO disadvantages below.
The last in first out method may seem counter-intuitive to some. And for most, it is. In fact it’s only allowed in the US and it’s banned by the International Financial Reporting Standards (IFRS). Last in first out is the opposite of FIFO in that the last items acquired by the business are the first ones sold. Most businesses could never implement LIFO because they would lose out on money due to spoiled goods and would experience lower profitability. The companies that decide to use LIFO over FIFO most often do it for the tax advantages. However, there can also be tax liabilities. The advantages of LIFO are also its disadvantages as the only real purpose of instituting LIFO is to avoid paying higher taxes but this means profits are generally lower.
LIFO has much more complicated cost layers than FIFO does. Cost layers are a way to keep track of the inventory, purchasing expenses and profits. Here’s an example to further demonstrate cost layers.
Example: Company A began business in 2013, at the end of 2013 Company A had 25 items in its inventory purchased at $5 each. This would be the first and only layer known as the base layer of LIFO. The base layer’s cost is $125. In 2014, Company A acquired 20 more units at a cost of $10 each but sold 15 of them. Using LIFO, you assume that the 15 items sold were sold at the most recent cost of $10 apiece. However, you still have the 25 items purchased in 2013 in stock. This creates a new layer. The inventory cost at the end of 2014 will be the base layer ($125) plus the remaining items from the new layer in 2014 (5 items at $10 = $50). This means the inventory cost is $175.
In 2015, let’s say that Company A acquires 100 items at $15 each but sells 105. With LIFO, we would assume that 100 items were sold at the most recent cost price of $15 each, while the remaining 5 items are being sold at the next most recent cost price of $10 each (from 2014). There are now three layers. The items purchased in 2013 are still in the inventory.
1. Like mentioned above, LIFO most often means lower profits for the company, but when you report lower profits, you don’t have to pay as many income taxes. This allows the business to have more cash-in-hand to use for investment opportunities or to purchase more inventory.
1. Because of inflation, where costs and expenses continue to rise, LIFO will have a lower profit margin than that of FIFO. This is because there is little to no inflation gap to allow LIFO businesses to capitalize on their inventory.
2. Because of LIFO’s generally lower reported profits, businesses utilizing this valuation of inventory can have a harder time finding investors. Individuals and businesses looking to invest their money are usually looking for companies that show substantial profit growth over a period of time. With LIFO, profits will rise with inflation but they will not reflect the kind of healthy business investors are seeking.
3. Due to the complexities of LIFO cost layers, accountants can have a difficult time accurately recording costs and expenses. This is especially true of large businesses that have many operations that implement different inventory management techniques.
In the end, FIFO is the most widely recognized and accepted valuation method for inventory management. It’s safer, easier and is more advantageous in the long run that dealing with the confusion and potential profit loss of LIFO. Learn more about inventory management techniques to help you make a sound decision for your business. You can also brush up on your accounting skills in our finance and accounting for start-ups course.
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