If your business sells a product, the method you use to value your inventory can have a significant effect on tax liability and financial ratios. LIFO, FIFO, and average cost are the most common inventory methods in the U.S. All three are acceptable for tax returns and GAAP reporting, although LIFO isn’t allowed under International Financial Reporting Standards.
Why Pick an Inventory Valuation Method?
Why is this important? Because you don’t always purchase inventory at the same price. Suppliers may give you a discount for bulk orders or for being a loyal customer. If you’re forced to switch suppliers, your purchase price may change. And, as time goes on, vendors will raise prices to keep up with inflation and a higher cost of living.
This creates a problem: How do you value identical units of inventory if you paid different prices for them? If you sell a small amount of expensive or specialized goods, you may be able to keep track of the actual cost and selling price of each item. But, as your inventory expands, it becomes impractical to keep track of the actual price paid for each individual unit of inventory. At this point you’ll need to choose one of these inventory valuation methods.
“First in, First out” — FIFO, for short — assumes that you sell your oldest inventory first. This system makes logical sense, especially for small businesses that sell inventory that can spoil or quickly becomes outdated. For example, if you own a convenience store, you’re going to try to sell the older milk that is closer to expiration before you sell newer milk.
In times of rising inventory prices, FIFO creates a lower cost of goods sold, more assets on the balance sheet, and a higher gross profit. If you’re trying to attract investors or secure new lines of credit, this may be what you want. More gross profit and assets means a better profit margin, return on equity, and return on debt — all very important metrics for potential investors and lenders.
On the downside, a higher net profit means more income tax, which is less actual cash in the bank. Savvy investors and lenders might know to ask about your inventory valuation method and be put off by the higher tax liability.
“Last in, Last out,” or LIFO, uses the opposite assumptions of FIFO. Under LIFO, the inventory you most recently purchased is considered to be the first sold. It can be appropriate for inventory that doesn’t tend to go bad, like metals or other raw materials. The problem is, because the oldest inventory may be never officially “sold,” LIFO can create layers of old inventory. This makes converting to another inventory method later a time-consuming, accounting headache.
Many companies find the financial benefits of LIFO outweigh the problems. In times of rising prices, LIFO creates a lower gross profit and reduces income tax liability. It’s nice to see a higher accounting profit, but most business owners prefer to have more cash in the bank.
Under this method, the value of a unit of inventory is the sum of total costs in inventory divided by the number of items in stock. As you sell and restock inventory, the average changes. If you use weighted average, your gross income will fall somewhere in between where it would under LIFO and FIFO. This method is fairly intuitive and doesn’t involve any accounting layers. In fact, you could calculate this on your own if you wanted to, and it comes standard in the professional versions of some accounting software.
Bare-bones accounting software doesn’t always come with an inventory tracking module. If you’re not ready to spring for inventory management software, there are reasonably-priced inventory add-ons available for your accounting package. Once you’ve decided on LIFO, FIFO, or weighted average, look for a module or add-on that supports your specific inventory method of choice.