FIFO or LIFO - What's the Difference? Which is Better?
FIFO and LIFO Inventory Methods - What's the Difference?
Around the end of a business's fiscal (financial) year, auditors and accountants start to talk about "taking inventory" and "LIFO vs. FIFO." But what's the difference between these terms, and which one is better for my business? This article looks at inventory in general and FIFO and LIFO as the two most common methods to value inventory.
How is Inventory Valued?
Let's start with the basics and keep things simple:
Companies that are producing products for sale, or who have purchased products from a wholesaler to re-sell, have inventory - a supply of those products or parts or materials. Inventory is a business asset since it has a value. At the end of the year each company must determine the cost of all the products in inventory in order to calculate cost of goods sold (COGS). Cost of goods sold is calculated as:
- Beginning inventory
- Plus purchases to inventory
- Less ending inventory
- Equals cost of goods sold.
As you can see, the cost of beginning and ending inventory is an important factor in COGS. How inventory is valued plays a big part in the business tax situation. The greater the cost of goods sold, the less the company's profits - and the lower the company's taxes.
Inventory valuation methods have been set by the accounting profession and the IRS tells businesses how they can value inventory. So, there's always a tension between accounting (companies want to minimize taxes) and the regulators (the IRS wants to maximize taxes).
Inventory Valuation Methods Described
Since inventory is constantly coming into and going out of a company, it's difficult to keep track of the cost of individual items inventory, so a generally accepted accounting principle allows businesses to use some general guidelines in valuing the cost of inventory:
- Specific Value Some types of products can be valued individually and a specific value assigned. For example, antiques, collectibles, artwork, jewelry, and furs, can be appraised and a value assigned. The cost of these items is typically the cost to purchase, so the profit can easily be determined.
- First-in, First-out (FIFO): Under FIFO, it's assumed that the inventory that is the oldest is being sold first. The FIFO method is the standard inventory method for most companies. FIFO gives a lower-cost inventory because of inflation; lower-cost items are usually older.
- Last-in, First-out (LIFO): LIFO is a newer inventory cost valuation technique (accepted in the 1930s), which assumes that the newest inventory is sold first. LIFO gives a higher cost to inventory.
- Average cost, which just takes the average cost of inventory sold. In this case, you would add up the cost of all items and divide by the number. This method works best for individually valued items.
Which is Better - LIFO or FIFO?
First, remember this: Higher-cost inventory = lower taxes. Lower-cost inventory = higher taxes. To assess the relative value of LIFO and FIFO inventory cost, you need to look at the way your inventory costs are changing:
- If your inventory costs are going up, or are likely to increase, LIFO costing may be better, because the higher cost items (the ones purchased or made last) are considered to be sold. This results in higher costs and lower profits.
- If the opposite its true, and your inventory costs are going down, FIFO costing might be better. Since prices usually increase, most businesses prefer to use LIFO costing.
- If you want a more accurate cost, FIFO is better, because it assumes that older less-costly items are most usually sold first.
IRS Regulations and FIFO vs. LIFO
As you might guess, the IRS doesn't like LIFO valuation, because it usually results in lower profits (less taxable income). But the IRS does allow businesses to use LIFO accounting, requiring an application, on Form 970.
The national accounting standards organization, the Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting. The international accounting standards body (IFRS) doesn't allow LIFO to be used, so if your company has international locations, you probably won't be able to use it.
Restrictions on Changing Inventory Methods
If your business decides to change to LIFO accounting from FIFO accounting, you must file Form 970 with the IRS, and you will not be allowed to go back to FIFO accounting unless the IRS gives specific permission. The IRS doesn't want businesses switching back and forth between the two types of valuations.
Periodic vs Perpetual Inventory and LIFO or FIFO
Businesses use one of two ways to manage inventory - periodic and perpetual. Periodic inventory management is tracked manually, counting at the end of an accounting period. Perpetual inventory is for larger businesses using point-of-sale technology.
Your business can use either LIFO or FIFO with either of these inventory management systems.
Recordkeeping Issues and Inventory Accounting
LIFO inventory accounting increases record keeping, because older inventory items may be kept on hand for several years, while under FIFO those older items are sold first, so recordkeeping requirements are less.
Talk to Your Tax Professional
The decision to change inventory methods or to change back is complicated and has many tax and accounting implications. This article provides general information, not tax or legal advice. Talk to your CPA and tax advisor and get opinions on your specific business situation before you attempt to make a change.