Choosing the proper inventory costing method can significantly impact your business’s financial health. Whether you're a small business owner or a seasoned accountant, understanding the differences between LIFO vs FIFO is crucial for making informed decisions. This blog will explore these two popular inventory costing methods, providing clear examples and insights to help you decide which best suits your needs.
Table of Contents
LIFO vs FIFO: Definition
LIFO (Last In, First Out) is an inventory costing method where the most recently purchased items are sold first. This means your ending inventory will comprise the oldest goods in stock. Commonly used in industries where inventory prices fluctuate frequently, LIFO is a widely utilized method.
On the other hand, FIFO (First In, First Out) operates on the principle that the oldest inventory items are sold first. Your ending inventory will, therefore, comprise the most recently purchased goods. FIFO is widely used in industries where inventory items have a short shelf life, or price stability is a priority.
| Method | Inventory Flow | Impact on Ending Inventory |
| LIFO | Last in, First Out | Oldest goods remain |
| FIFO | First in, Last Out | Newest goods remain |
LIFO vs FIFO: Examples
Let’s say you run a retail business and purchase inventory at different prices throughout the year. Here’s how LIFO and FIFO would work:
- LIFO Example:
- January: Buy 100 units at $10 each.
- June: Buy 100 units at $12 each.
- You sell 100 units in December. Under LIFO, the units sold would be valued at $12 each (the most recent purchase).
- FIFO Example:
- Using the same purchase scenario, under FIFO, the 100 units sold in December would be valued at $10 each (the oldest purchase).
These examples highlight how the choice of inventory costing method can affect your cost of goods sold (COGS) and, ultimately, your profitability.
LIFO vs FIFO: Taxes
Regarding taxes, the choice between LIFO and FIFO can have significant implications.
- LIFO and Taxes: Since LIFO uses the most recent inventory costs, it often results in higher COGS and lower taxable income in times of rising prices. This can lead to tax savings but might also lower reported profits.
- FIFO and Taxes: With FIFO, the oldest costs are used first, which generally results in lower COGS and higher taxable income. While this might mean paying more taxes, it reflects higher profitability on financial statements.
LIFO vs FIFO: When to Use
When to Use LIFO:
- When prices are rising, and you want to reduce taxable income.
- Industries with volatile inventory prices, like oil and gas.
When to Use FIFO:
- When you want to maximize reported profitability.
- It is ideal for businesses with perishable goods or stable pricing.
FIFO vs LIFO: Advantages and Disadvantages
FIFO Advantages:
- It is simpler to implement and understand.
- Reflects actual inventory movement.
FIFO Disadvantages:
- Higher taxable income in inflationary periods.
LIFO Advantages:
- Potential tax savings in times of rising prices.
LIFO Disadvantages:
- More complex to implement.
- It may not reflect actual inventory movement.
Conclusion
Choosing between LIFO and FIFO depends on various factors, including your industry, pricing trends, and financial goals. Both methods have advantages and disadvantages; the right choice will depend on your circumstances.
Understanding these differences and how they affect your financial statements will better equip you to make the best decision for your business.
