LIFO and FIFO are popular inventory valuation methods. While both track inventory, there are significant differences between the two. Learn these differences and decide which method is right for you.
Last in/first out (LIFO) and first in/first out (FIFO) are the two most common types of inventory valuation methods used. Both LIFO and FIFO are GAAP-approved inventory methods, but if you decide to use LIFO, you’ll need to complete a special application with the IRS for approval.
If you do receive permission to use LIFO in your business, you will not be able to return to FIFO without permission from the IRS.
If you do business globally, you’ll need to stick with FIFO or another approved inventory valuation method since the international accounting standards body (IFRS) prohibits the use of LIFO.
The main difference between LIFO and FIFO is based on the assertion that the most recent inventory purchased is usually the most expensive. If that assertion is accurate, using LIFO will result in a higher cost of goods sold and less profit, which also directly affects the amount of taxes you’ll have to pay.
What is LIFO?
The LIFO method assumes the last items placed in inventory are the first sold.
For instance, if you purchase 100 units on May 15 for $500 and 100 units on May 27 for $750, and you sell 150 units on May 31, all of the more expensive units that were purchased on May 27 would be sold first, along with 50 of the less expensive units that were purchased on May 15.
What is FIFO?
The FIFO method assumes the oldest items in inventory are sold first. Using the same example as above, with 100 units purchased on May 15 for $500 and 100 units purchased on May 27 for $750, when you sold 150 units on May 31, you would sell all of the May 15 units along with 50 of the May 27 units.
LIFO vs. FIFO: What's the difference?
LIFO and FIFO are inventory valuation methods that work on different premises. While the names are self-explanatory, remember that the method you choose will directly affect your key financial statements such as your balance sheet, income statement, and statement of cash flow.
As mentioned earlier, LIFO will increase inventory valuation and lower net income, while FIFO will lower inventory valuation and increase income, based on the assumption that later inventory purchases are more expensive.
However, if the units had been purchased on May 15 and May 27 for the same amount, there would be no impact on financial statements.
Use cases for LIFO
Most companies prefer FIFO to LIFO because there is no valid reason for using recent inventory first, while leaving older inventory to become outdated. This is particularly true if you’re selling perishable items or items that can quickly become obsolete.
While in most cases, FIFO is the better option, LIFO can be used for the following reasons:
- Better matching of product cost with revenue: By selling newer inventory products first, the cost will be better matched with revenue. If older, less expensive inventory is sold first, the profit level of the business will be artificially inflated.
- Lower taxes: Using the more expensive products first will lower net income and, in turn, lower profits, which means your business will have a lower taxable income income.
Use cases for FIFO
FIFO is the preferred inventory valuation method for most businesses for a variety of reasons. If your products are perishable, have an expiration date, or quickly become obsolete, FIFO is the only method you should use. Here are some additional reasons you may choose to use FIFO:
- Easier to manage: FIFO is easily understood, and it’s the accepted method of the IRS as well as international businesses.
- More accurate financial statements: Using FIFO makes it much harder to manipulate company finances.
- You have international locations: If you have international locations, the IRS requires you to use FIFO for inventory valuation.
- Product costs are dropping: If your product costs have dropped, it’s beneficial to use FIFO, which will increase your cost of goods sold while lowering net income, allowing you to reduce your taxes.
- Easier tracking: FIFO is tracked based on the natural flow of inventory, which means older products will be sold first. This eliminates the possibility of older and possibly obsolete inventory that cannot be sold remaining on the books.
Example of LIFO
Using the following example, we’ll be able to see how LIFO and FIFO affect the cost of goods sold and net income.
Donna’s Doors started the month of May with $20,000 in inventory. That inventory includes 200 doors that Donna purchased for $100 each. In May, Donna purchased 125 more doors at varying prices:
On May 30, a customer purchased 150 doors at a cost of $250 per door. Here’s how the inventory is valued using LIFO:
Using the LIFO valuation method, the cost of goods sold reflects the value of the inventory that was included in the latest purchase. A total of 150 doors were sold, using inventory as follows:
25 doors @$125 = $3,125
50 doors @$120 = $6,000
50 doors @$110 = $5,500
25 doors @$100 = $2,500
Using LIFO, the total cost of goods sold is $17,125.
Example of FIFO
Now, using the same scenario as above, we’ll calculate the cost of goods sold and net income using FIFO:
Using FIFO, your cost of goods sold reflects the cost of the oldest inventory. The inventory breakdown is simple:
150 doors @$100 = $15,000
Because all 150 doors came from the oldest inventory that was already in stock as of May 1, it isn’t necessary to include any of the recent purchases in your cost of goods sold calculation.
Notice by using the older, less expensive inventory first, the ending inventory value has increased, as has your net income. If inventory costs had remained the same, the cost of goods sold and, subsequently, your net income would have also remained the same.
LIFO vs. FIFO really does matter
If you sell or plan to sell products, proper inventory management is a necessity.
Deciding whether to use LIFO or FIFO can be complicated, so be sure to consider both options carefully before making a decision, since the inventory valuation method you choose also will also have a significant impact on your financial statements.
You also need to remember that you need special permission from the IRS in order to use the LIFO method, and if you do business internationally, you cannot use LIFO at all.
If you’re still manually tracking inventory, now’s a good time to consider making the move to accounting software. If you’re not sure where to start, be sure to check out The Ascent’s accounting software reviews.
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