Inventories are one of the largest and critical components appearing in the current assets section on your company’s balance sheet . These are defined as assets either held for sale or consumption during production of goods or rendering of services.
Now, there is a difference in the prices when you purchase inventory at different time periods. This is because as a company you cannot purchase the inventories all at one time. Further, the price at which you disseminate the raw materials directly impacts your company’s cost of production. Thus, it is imperative for the companies to be cautious while choosing the method for valuing inventories.
Inventory valuation helps to determine the value of unsold goods, cost of goods sold as well as goods purchased during the period. These transactions are reported in the financial statements of the company at the end of the accounting period. Thus, the ending inventory impacts a company’s balance sheet whereas the cost of goods sold impact a company’s income statement.
Therefore, the company must be careful in choosing the inventory valuation method. This is because the choice of inventory valuation method has a significant impact on a company’s profit, taxes and closing inventory.
Thus, there are various methods used for valuing inventory by the companies. These include FIFO, LIFO and Weighted Average Cost Methods. FIFO and LIFO are the most common inventory valuation methods that businesses use. Hence, this article will help you understand FIFO Vs LIFO. That is the differences between FIFO and LIFO with their inherent advantages and disadvantages.
1. First In First Out Method (FIFO)
The First In First Out Method assumes that goods are consumed in the sequence in which they are purchased. This means that the goods purchased first are consumed first in case of a manufacturing concern. And goods purchased first are sold first in case of a merchandising firm.
Consequently, goods purchased recently form a part of the ending inventory under this method. Thus, the net income tends to increase under FIFO method as the ending inventory tends to reflect the current price in the market. This is because goods first purchased are used in calculating the cost of goods sold under FIFO method.
Thus, one needs to consider that increased income can mean increased taxes for the business. Although increased net income may be a positive indication. Furthermore, the impact of inflation gets reduced for companies following FIFO method of inventory. This is because companies use or sell oldest items first and the newer items later. Consequently, it reduces the impact of inflation as the company sells or uses oldest items at current inflated prices.
So, let’s consider the example of Kapoor Mart to better understand the First In First Out Method of Inventory valuation method.
Case I – Under Periodic Inventory System
FIFO method is used to determine the cost of ending inventory for companies using periodic inventory system. This is done by taking the cost of the latest or the most recent purchase. And then calculation is done backwards till the time all the items in inventory are considered.
Therefore, ending inventory and cost of goods sold are calculated as follows:
Cost of Goods Available for Sale Rs 43,900
(-) Ending Inventory Rs 27,100
Cost of Goods Sold Rs 16,800
Case II – Under Perpetual Inventory System
Cost is attached to each withdrawal or sale of items under perpetual inventory system. Accordingly, goods sold on October 18, 2018 would comprise of purchases made on October 8 and October 14, 2018.
So, sales made on October 18, 2018 would comprise of the following on using the FIFO made as per the above table:
- Purchases made on October 8 (2000 units @ Rs 4.00 = Rs 8,000) and
- Purchases made on October 14 (6000 units @ Rs 4.40 = Rs 26,400)
Thus, the ending inventory according to this method is Rs 27,100 and the cost of goods sold is Rs 16,800.
Advantages of FIFO Method
- The advantage of using FIFO method is that it does not allow any manipulation of income. This is because the business cannot choose certain cost item and take it as expense. In other words, items purchased first need to be charged first.
- Another advantage of using this method is that the ending inventory is taken at the most recent cost. Thus, FIFO method provides a close approximation of the replacement cost on balance sheet since the ending inventory is made up of the most recent purchases. This happens in cases when there are no price changes from the time latest purchases are made.
Disadvantages of FIFO Method
The disadvantage of using FIFO method is that there is a mismatch between the current costs and the current revenues. This is because the oldest costs are taken and are matched with the current revenue which can lead to misleading profit figures.
2. Last In First Out Method (LIFO)
The LIFO Method assumes that recent goods purchased are consumed first and the goods purchased first are consumed later. Thus, cost of goods sold is calculated using the most recent purchases. Whereas the ending inventory is costed using the cost of the oldest units available.
Consequently, ending inventory reflects items that are extremely old under this method. This results in valuing inventory at costs lower than the current prices. So, the net income tends to decrease under LIFO method. And the ending inventory reflects prices lower than the current price in the market. This is because goods purchased last are used in calculating cost of goods sold under LIFO method.
Furthermore, the impact of inflation increases for companies following LIFO method of inventory. This is because companies use or sell current items first and the older items later. Consequently, it increases the impact of inflation as the company sells or uses current items at current inflated prices only.
Case I- Periodic Inventory System
The total quantity of sales made during the month would have come from the latest purchases if the company uses periodic inventory system .
Goods Available For Sale Rs 43,900
(-) Ending Inventory Rs 25,600
Cost of Goods Sold Rs 18,300
Hence, 4000 units sold on October 14, 2018 would comprise of the following as per the above table:
- 2000 units purchased on October 30, 2018 and
- 2000 units out of 6000 units purchased on October 14, 2018
Case II – Perpetual Inventory System
Companies will have different ending inventory and cost of goods sold as against the periodic inventory system if they use
perpetual inventory system for recording inventory and
LIFO method for inventory valuation
As per the above table, sales made on October 18, 2018 would comprise of the following on using the LIFO method:
- Purchases made on October 14 (4000 units @ Rs 4.40 = Rs 17,600)
Thus, the ending inventory according to this method is Rs 23,600 and the cost of goods sold is Rs 17,600.
So, this shows FIFO and LIFO impact the total cost of inventory at the end of the year under various inventory systems. Therefore, to help you understand this in a much easier way, here is an infographic on FIFO Vs LIFO.