The first in, first out method (FIFO) and last in, first out method (LIFO) are the two standard inventory valuation types. Each offers unique benefits, depending on your business model, with key differences setting them apart.
In this FIFO vs LIFO blog post, you will learn:
- The precise definition of each term
- The main differences between LIFO and FIFO to understand the most suitable one for your business
- How to optimize your inventory methods using modern technology
FIFO vs LIFO: Understanding Inventory Valuation Methods
Learn the meaning of LIFO and FIFO and how each method works in inventory management.
FIFO Definition and Example
When you use the FIFO method to record the cost of sold inventory in your financial statements, you assume the oldest items (the inventory you bought or produced first) are the first ones you sell.
Here’s an example: On January 1st, Jalaram Automotive manufactured 500 engine valves at $10 each. The following month, the company produced 300 more units at $13. Jalaram Automotive now has 800 engine valves in stock. Of these, it sells 700 units in March. Using the first in, first out method, the cost of goods sold (COGS) would be as follows:
Out of the 700 units sold in March, the first 500 come from the January 1st inventory (first-in stock), costing $10 each. Therefore COGS = 500 units × $10 = $5,000. The next 200 units sold originate from the inventory batch Jalaram bought in February, which cost $13 each. For this reason, COGS = 200 units × $13 = $2,600. The total FIFO cost of goods sold in March = $5,000 + $2,600 = $7,600.
Suppose Jalaram wants to calculate the remaining or unsold inventory cost using the FIFO technique. In that case, it uses the price of the most recent inventory purchases (February batch) since all units from the first inventory (January batch) have been sold.
- The inventory balance (remaining stock): 800 total units − 700 sold units = 100 engine valves
- Cost of remaining inventory: 100 units × $13 cost per unit = $1,300
LIFO Definition and Example
The LIFO inventory method is the opposite of FIFO. With this inventory valuation technique, you assume that the most recent items in inventory will be sold first (hence the name last in, first out). As a result, you calculate COGs using the cost of the most recent stocks.
For example, the car manufacturer Bain Motors uses LIFO for its tire inventory. In January, the company bought 1000 tires at $50 each (batch A). In February, it obtained an additional 1,500 tires at $55 (batch B). In March, Bain Motors sold 1,700 tires. What’s the cost of goods sold in March?
Under the last-in, first-out method, Bain sold their most recent (last-in) inventory first. That means out of the 1,700 tires sold in March, 1,500 came from batch B, resulting in COGS that amount to (1500 tires × $55) $82,500. The next 200 tires sold came from batch A with a cost of goods that amounted to (200 × $50) $10,000. Total COGS in March is ($10,000 + $82,500) $92,500.
5 Key Differences Between FIFO and LIFO
With FIFO, the inventory bought or manufactured first (the oldest stock) is sold first. On the other hand, LIFO involves selling the most recent stock ahead of the oldest inventory. This is the obvious difference between the two inventory management techniques, but the contrasts run deeper.
1. Accuracy in Reflecting an Item’s Current Market Price
FIFO reflects the current prices of a product more accurately than LIFO when the prices in the industry are rising. That’s because you calculate the value of inventory using the cost of older inventory, which is closely related to the actual market price of material rather than the most recent inventory costs (as in LIFO) hyped by inflation.
2. Level of Profits Based on Cost of Goods Sold (COGS)
FIFO can increase the profits you report in your financial statements. With FIFO, you prioritize the cost of the oldest stocks (which were cheaper back then than current inflated inventory costs) to calculate COGs. The lower the cost of goods, the higher the net income in your financial statements.
On the other hand, LIFO prioritizes the cost of your most recent inventory when determining COGs. This cost might be higher than that of older stocks in your storage facilities, especially during periods of inflation. As a result, LIFO generally increases the cost of goods sold, lowering the profits you record in your books.
3. Taxable Income and Financial Statements
FIFO tends to increase the net income in your balance sheet and income statement by reducing the cost of goods sold. Higher profit margins raise your taxable income, increasing your tax liabilities.
On the contrary, LIFO increases COGS and reduces net profits reported in your financial statements. Low profits minimize your taxable income, which reduces your tax liability.
4. Industry Considerations and Types of Goods
FIFO is common in industries with perishable products or where inventory turnover is rapid. Because it ensures older stocks (inventory that got in the warehouse first) are sold first, it prevents products that go bad quickly from spoilage while in storage.
Meanwhile, LIFO is prevalent in sectors with stable or declining prices. That’s because it can better reflect the current value of the remaining inventory during deflation. Additionally, LIFO is only suitable for nonperishable inventory items. It’s unsuitable for perishable products since the first inventory is sold last.
5. Technology Necessary for Record-Keeping and Management
While you can use LIFO or FIFO without recording-keeping technology, manually implementing them can be slow and time-consuming. Leveraging inventory or warehouse management systems makes it easy to deploy either of the inventory valuation techniques.
However, FIFO is more common than LIFO due to being globally approved by the International Financial Reporting Standards and following the natural inventory flow. LIFO is not globally approved. For this reason, it’s easier to find inventory management solutions with features supporting FIFO record-keeping than LIFO.
Streamline Inventory Management With Surgere
When looking for a software solution that will make your inventory management easier and more accurate, Surgere is the right technology for you. It provides real-time visibility, allowing you to manage your assets with 99.9% accuracy. The solution is also equipped with automated FIFO technology to show you what items came in first in your facility and which ones should move out first. This ensures you stick to your FIFO inventory and warehouse management strategy. Contact Surgere today to learn how our technology streamlines your stock handling.
