LIFO vs. FIFO

The two methods used to manage a company's inventory.

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Last Updated:November 21, 2023

What is LIFO vs. FIFO?

There are many methods accountants use to manage certain aspects of financial statements, such as the balance sheet, income statement, and statement of cash flows. 

Each method has to do with inventory accounting, which aligns with supply and demand. Many businesses want to have as much inventory as possible on hand to meet demand and not to lose money simultaneously. 

One of the primary methods used is Lifo or Fifo, two methods used to manage a company's inventory. They are both important, and while one method may work better for a company, they are both useful in their own way. 

Inventory is a major aspect of a company. Having more than enough reserves on account while also not having too little is a delicate balance to try and maintain. By the same token, in the event something like that were to happen, companies have to rely on accountants to be aware of these potential dangers to the company. 

Depending on the type of organization, some inventory can go bad the longer you have it. This is prevalent in the food industry, where many businesses either have to find safe places to store their items or just keep making new ones every day. 

Today, we will be explaining the differences and similarities between Lifo and Fifo and how companies use them to manage their inventories effectively. 

What Is Inventory?

Inventory is a major aspect of a company, and managing it usually is a big determinant as to whether or not it can handle the ups and downs of the demand and supply and ultimately come out on top as a successful company. 

In the production, inventory is usually accounted for in three steps:

  • Step 1 - Raw materials that are goods
  • Step 2 - Goods already in production
  • Step 3 - Finished goods ready to be sold

Essentially, you factor in the goods you have at first, which are the raw materials.

Then, you add the goods already in production and subtract the amount of ending inventory left in your inventory after sales. . You are left with the COGS, commonly known as the Cost of Goods Sold. 

This method of accounting based on the inventory available is more formally known as Inventory Accounting. The stages of production combine these goods into the classification of assets. 

Over time, as inventory gets sold off, it becomes a means of revenue for the company, making them profitable. 

The formula for inventory is as follows:

BI + Net Purchases - COGS = EI

Where,

  • BI = Beginning Inventory
  • EI = Ending inventory
  • COGS = Cost of Goods Sold

First-In, First-Out (FIFO)

The first-in, first-out method is one used, assuming that the first item that is being taken into inventory or rather purchased first will be sold first. This can also be said as the oldest inventory being pushed out first. 

It may sound confusing but remember that all of this is dealing with the work of accountants, which mainly falls under these consolidated sheets for which they jot their journal entries. To offer some clarification, here's an example:

For example, suppose a baker in a bakery baked 400 loaves of bread on Monday. Let's say that these loaves of bread cost $1 each. Now picture the baker baking another batch of 400 loaves of bread on Tuesday, but they cost $1.25 each. This would cause a $100 increase in cost. This seems like an inconsequential amount, but for larger businesses, every change in cost counts. 

FIFO says that the baker should sell the first batch of bread that costs $1 first. So, if the bakery sold 400 loaves on Wednesday, the cost of goods sold is $1 per loaf because that was the price of the first loaves in the inventory. 

The loaves, which cost $1.25, would then be moved to the ending inventory and would be sold later. The cost of goods sold is found on the balance sheet, and the ending inventory is found on the income statement. 

Last-In, First Out (LIFO)

The last-in, first-out method makes the assumption that the last item in the inventory is the first one to be sold. In regard to the inventory, which is older, at the end of the accounting period, it is then left over. 

Back to the example of the baker and the loaves of bread, for the 400 loaves sold on Wednesday, the same bakery could make each loaf at $1.25 cost. 

This would cause a larger cost incurred to manufacture these goods, which totals more expenses for the business overall. At the same time, the remaining loaves, which were priced at $1, would then be used to calculate the inventory and the value it has when the period is over. The changes to the overall amount of inventory play a huge role in the way in which companies go about accounting for their future decision-making. 

The last-in, first-out method uses the inventory, which is the most recent, to evaluate the value of COGS. Likewise, the leftover inventory could be old and not of much use anymore. 

These methods, compared to that of LIFO, do not truly give an accurate representation of the value of certain inventories or even do the job of keeping up to date with them. This is due to the fact that certain valuations can be made to be lower due to rapid changes in prices today versus that of tomorrow.  

Likewise, last-in, first-out is not good for many businesses because they do not want to leave their inventory which is older, sitting in stock, not doing anything, and essentially deteriorating. The main objective is to use the most recent inventory. 

This idea makes sense, especially in the case of the baker, as the bakery would much rather sell the freshest bread first and leave the older bread to be thrown out. This can lead to losses as the food can spoil, which is not good from a profitability standpoint. 

This goes to show that last-in, first-out isn't as easy for companies to use, especially ones that sell perishable goods, which over time, lose value. 

LIFO vs. FIFO

Between both methods, many people might ask the question of which one is better and more effective at an increasing profit. 

FIFO is commonly considered to be more trusted, reliable, and easier to understand when it comes to calculating the cost of goods sold. 

The ideological concept of the "First-In, First-Out" method is easier to grasp for someone just learning the difference between the two. 

Most businesses, out of their own best interest, get rid of their oldest products first, especially in the food industry, as nobody wants expired food because it can be a major liability. 

Another reason for this is that older inventory in other sectors can just naturally deteriorate over time to the point of no useability. As a result, this ends up costing businesses more money in the long run. 

As such, first-in, first-out is just following the stereotypical way of keeping an inventory while slimming down the margin of error and decreasing the chance of something going wrong along the way while writing down book recordings.

On the flip side, there has to be a case made for last-in, first-out, as companies would not use it as an inventory-keeping method if it was flawed. It allows a company or business to utilize the inventory which is most recent first. 

Usually, these companies pay more as the cost is, most of the time, higher than what normally would be the price of acquiring or putting older inventory into production. Subsequently, your profits could take a hit and could end up being lower as a result. 

Likewise, it is true that under LIFO, companies can pay less in taxes under this method. Conversely, it is also true that profits which are documented under FIFO are more accurate. 

This may seem weird, but the reason for these profits being more accurate is because inventory that is older actually shows the actual cost of the items in that inventory. 

Sometimes, businesses have to adjust their prices for inflation over time, but the regular price they obtain for good is what it is. 

If we believe that profits a business takes in are going to be higher with the FIFO method, this allows the company to gain more traction and be perceived better and safer from an investment standpoint.

There are always downsides and problems with each method. For example, one of the main problems with last-in, first-out is that the books, along with the financial statements, are easier to get around and bend in order to change the way it is perceived. 

Another problem with a company using the LIFO method is that the older inventory can actually be on their books forever, and the inventory which is older and has not perished or deteriorated by this time is not going to reflect their value in the current market as it stands that day.

As a result, this inventory will be understated, with the chance of a company not having an accurate view of its inventory. 

In summary, in answer to the question of which method is better, it is generally perceived as best practice to go with the first-in, first-out method of FIFO as the method for keeping inventory. 

Example of LIFO vs. FIFO

Now that we have outlined some key logical differences between the two, in order to fully understand what makes them different, it's best to give some more examples of both the methods and how they are applied numerically.  

Suppose that you have got your business up and running in the city of your choice. Your business model and structure are based on selling mini-fridges to consumers, and the name of your company is RigidFridge. You are required to keep an inventory, as every business should. 

Keep in mind that units are mini-fridges, and you have 2,900 of those in total. After doing an overview of your inventory, this is what you kept a journal entry of.

Journal Entry
Month Amount (Units) Price Paid
January 200 $1,600.00
February 200 $1,600.00
March 200 $1,650.00
April 200 $1,650.00
May 200 $1,650.00
June 200 $1,650.00
July 200 $1,700.00
August 250 $1,750.00
September 250 $1,800.00
October 250 $1,800.00
November 250 $1,800.00
December 250 $1,800.00

As you can tell, the price per unit starting in August increased by 50 units and continued to be produced at that same number for each subsequent month. Assuming you, as a business owner, kept your sales price the same, which is actually the smartest thing to do if you want to stay competitive. 

As a result, this would mean there was less of a profit to take in for your mini-fridge company by the end of the year. You had 2,900 units of mini fridges to sell, and let's say you sold 2,200.

Now let's use the different inventory accounting methods of FIFO and LIFO to calculate the cost of goods sold. 

FIFO Method:

Going by this method, you would need to use the older costs of acquiring the inventory and go from there.

So Rigid Fridges Cost of Goods Sold calculation is as follows:

200 units x $1,600 = $320,000

300 units x $1,650 = $495,000

200 units x $1,700 = $340,000

300 units x $1,750 = $525,000

100 units x $1,800 = $180,000

The total amount of Rigid Fridges cost of goods sold totals out to be $1,860,000.00

LIFO Method:

Now let's take a look at how this method would work. Rigid Fridges needs to assess themselves as first they buy the most recent inventory and then work backward from there.

450 units x 1,800 = $810,000

300 units x 1,750 = $525,000

200 units x 1,700 = $350,000

150 units x $1,650 = $247,500

Ted's cost of goods sold is $1,932,500.00

You can now see that for your business; Rigid Fridges would be better off using the LIFO method as opposed to that of FIFO. 

The reason for this is due to the fact that the number you get from LIFO represents a higher inventory cost, $31,250 to be exact, which in turn means fewer taxes; but also less profitable. The remaining unsold 350 mini-fridges are noted down and journaled under "inventory."

As you can now see, each method has its own way of doing things. Nevertheless, both methods are formidable for companies to use, depending on the sizes of their inventory and the items in which they are storing within it. 

Summary

In summary, it is important to understand the differences between the Last-In, First-Out, and First-In, First-Out methods. These methods are crucial for a business in terms of its inventory and how they account for certain items. 

Items that are FIFO benefit businesses partially in the food industry. It makes sense, as with food, most of the time, you want the freshest food available in the amount of time you can. Likewise, you want to start the day with the freshest inventory, so the first ones in will cause the oldest ones to go out. 

For LIFO purposes, it is important to remember the discrepancy between how prices can change over time. Due to inflation, or even company pricing between common day-to-day demands, certain prices of goods can be worth more or less tomorrow than they are today. 

These changes are important notes for inventory in doing the best a company can save the most amount of money possible for their business. 

Researched and authored by Daniel Bartels | LinkedIn

Edited By Sakshi Uradi | LinkedIn

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