There are two main methods of inventory valuation. First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). These can help you determine how much money your firm has tied up in finished goods, components, and/or raw materials. FIFO and LIFO pick inventory by the age of the item. This ensures the rotation of products, so you are picking items before their expiry dates.
When a business uses FIFO, the first item in inventory is the first item to sell. As a result, ending inventory is what was most recently purchased or manufactured. This is the most popular method of inventory management as it is easier to use and more practical than LIFO. When it comes to perishable goods. FIFO is common.
LIFO is the opposite. In this case, the last items in inventory are the first to sell. Which means the ending inventory consists of the oldest goods. This method may seem counter-intuitive to some. And for most companies, it is. It’s banned in Canada for accounting practices and is only allowed in the US. Most businesses could never use LIFO, as spoiled goods would mean lower profits. Usually, companies that use LIFO do it to avoid paying higher taxes. However, this also means profits are generally lower.
So what’s the key difference between LIFO and FIFO?
| FIFO | LIFO | |
|---|---|---|
| Stands for | First-In, First-Out | Last-In, Last-Out |
| Unsold Inventory | Most recent goods | Earliest acquired goods |
| Restrictions | No GAAP or IFRS restrictions | IFRS does not allow LIFO |
| Effect of Inflation | Increasing costs = Cheaper acquired goods (Decreases COGS and increases profit), larger income tax, higher value of unsold inventory | Increasing costs = Expensive acquired goods (Increases COGS and decreases profit), smaller income tax, lower value of unsold inventory |
| Effect of Deflation | Lower accounting profit, lower value of unsold inventory | Higher accounting profit, higher value of unsold inventory |
| Record Keeping | Less maintenance of records | More maintenance of records |
| Fluctuations | No unusual increase or decrease in inventory (Cost is more recent) | Unusual increase or decrease in cost of goods |
Overall, FIFO is the most widely recognized and accepted valuation method for inventory. It’s more practical, easier, and safer for companies and consumers. It’s important to learn more about inventory management techniques to help make smart decisions for your business.
