FIFO vs. LIFO: What is the difference?

Inventory is often the most significant asset balance on the balance sheet. If you operate a retailer, manufacturer, or wholesale business, inventory may require a large investment, and you need to track the inventory balance carefully. Managing inventory requires the owner to assign a value to each inventory item, and the two most common accounting methods are FIFO and LIFO.

The first in, first out (FIFO) cost method assumes that the oldest inventory items are sold first, while the last in, first out method (LIFO) states that the newest items are sold first. The inventory valuation method that you choose affects cost of goods sold, sales, and profits.

The average cost is a third accounting method that calculates inventory cost as the total cost of inventory divided by total units purchased. Most businesses use either FIFO or LIFO, and sole proprietors typically use average cost. Accounting standards allow companies to use all three methods.

Before diving into the inventory valuation methods, you first need to review the inventory formula. The components of the formula are used to calculate FIFO and LIFO accounting values.

Understanding the inventory formula

The value of inventory is determined using the ending inventory formula:

Beginning inventory + purchases = goods available for sale – cost of goods sold (COGS) = ending inventory

Let’s assume that a sporting goods store begins the month of April with 50 baseball gloves in inventory and purchases an additional 200 gloves. Goods available for sale totals 250 gloves, and the gloves are either sold (added to cost of goods sold) or remain in ending inventory. If the retailer sells 120 gloves in April, ending inventory is (250 goods available for sale – 120 cost of goods sold), or 130 gloves.

As you review the FIFO and LIFO inventory systems below, consider that goods available for sale end up in one of two places: cost of goods sold or ending inventory.

FIFO and LIFO produce a different cost per unit sold, and the difference impacts both the balance sheet (inventory account) and the income statement (cost of goods sold).

How are FIFO and LIFO methods different?

FIFO and LIFO inventory valuations differ because each method makes a different assumption about the units sold. To understand FIFO vs. LIFO flow of inventory, you need to visualize inventory items sitting on the shelf, each with a cost assigned to it.

Inflation is the overall increase in prices over time, and this discussion assumes that inventory items purchased first are less expensive than more recent purchases. Since the economy has some level of inflation in most years, prices increase from one year to the next.

Finally, the difference between FIFO and LIFO costs is due to timing. When all inventory items are sold, the total cost of goods sold is the same, regardless of the valuation method you choose in a particular accounting period.

Here are the critical differences between FIFO and LIFO:

Using FIFO for inventory valuation

FIFO assumes that the oldest items purchased are the first items sold, and older inventory items are less expensive than recent purchases. Using FIFO generates these results:

• Cost of goods sold: Selling the older (cheaper) units first generates a lower cost of goods sold than LIFO.
• Ending inventory: The newer, more expensive units remain in ending inventory, which is a higher balance than the LIFO method.
• Net income (profit): The lower cost of goods sold balance means that the FIFO method generates a higher profit than LIFO.

When you sell the newer, more expensive items first, the financial impact is different, which you can see in our calculations of FIFO & LIFO later in this post.

Inventory valuation using LIFO

LIFO assumes that the most recent inventory items are sold first, which are the most expensive. The financial results using LIFO are:

• Cost of goods sold: Selling the more expensive units first generates a higher cost of goods sold than FIFO.
• Ending inventory: The older, less expensive units remain in ending inventory, which is a lower balance than the FIFO method.
• Net income (profit): The higher cost of goods sold balance means the LIFO method generates a smaller profit than FIFO.

In sum, using the LIFO method generally results in a higher cost of goods sold and smaller net profit on the balance sheet. When all of the units in goods available are sold, the total cost of goods sold is the same, using any inventory valuation method.

Assume that the sporting goods store sells the 250 baseball gloves in goods available for sale. All costs are posted to the cost of goods sold account, and ending inventory has a zero balance. It no longer matters when a particular item is posted to the cost of goods sold account since all of the items are sold.

To solidify your understanding of these concepts, let’s review a simple example of the calculations.

How do you calculate FIFO and LIFO?

To explain inventory valuation in detail, assume that Sterling Fashions sells a line of men’s shirts and that the store had no beginning inventory balance on March 1st. Here is the inventory activity for March:

The store purchased shirts on March 5th and March 15th and sold some of the inventory on March 25th. The company’s bookkeeping total inventory cost is $13,100, and the cost is allocated to either the cost of goods sold balance or ending inventory. Two hundred fifty shirts are purchased, and 120 are sold, leaving 130 units in ending inventory.

A company’s recordkeeping must track the total cost of inventory items, and the units bought and sold.

We’ll calculate the cost of goods sold balance and ending inventory, starting with the FIFO method.

FIFO accounting results

To calculate the cost of goods sold, start with the oldest units. In this case, the store sells 100 of the $50 units and 20 of the $54 units, and the cost of goods sold totals $6,080.

The newer units with a cost of $54 remaining in ending inventory, which has a balance of (130 units X $54), or $7,020. The sum of $6,080 cost of goods sold and $7,020 ending inventory is $13,100, the total inventory cost.

The LIFO valuation method produces a different result.

LIFO inventory values

Cost of sales using LIFO includes the newest units purchased at $54. The balance is (120 units X $54), or $6,480. The oldest, less expensive items remain in the ending inventory account. The store’s ending inventory balance is 30 of the $54 units plus 100 of the $50 units, for a total of $6,620. The sum of $6,480 cost of goods sold and $6,620 ending inventory is $13,100, the total inventory cost.

FIFO generates a lower-cost goods sold balance than LIFO and a higher ending inventory balance. However, only 120 of the 250 units of goods available for sale are sold. What is the financial impact when all the inventory is sold?

Inventory values when all units are sold

When all 250 units are sold, the entire inventory cost ($13,100) is posted to the cost of goods sold. Let’s assume that Sterling sells all of the units at $80 per unit, for a total of $20,000. The profit (taxable income) is $6,900, regardless of when inventory items are considered to be sold during a particular month.

The impact of using FIFO or LIFO reverses over time. FIFO assumes that cheaper items are sold first, generating a higher profit than LIFO. However, when the more expensive items are sold in later months, profit is lower. LIFO generates lower profits in early periods and more profit in later months.

FIFO is the more straightforward method to use, and most businesses stick with the FIFO method.

How do FIFO and LIFO affect more straightforward accounting operations?

Using FIFO simplifies the accounting process because the oldest items in inventory are assumed to be sold first. When Sterling uses FIFO, all of the $50 units are sold first, followed by the items at $54.

Let’s expand the example and assume that the store-bought items at five different prices, rather than two. Here are the prices in order: $50, $54, $55.60, $57, $58.25. FIFO still assumes that the $50 items are sold first.

LIFO is more difficult to account for because the newest units purchased are constantly changing. In the example above, LIFO assumes that the $54 units are sold first. However, if there are five purchases, the first units sold are at $58.25.

The LIFO method requires advanced accounting software and is more difficult to track. Keep your accounting simple by using the FIFO method. You’ll spend less time on inventory accounting, and your financial statements will be easier to produce and understand.

The Sterling example computes inventory valuation for a retailer, and this accounting process also applies to manufacturers and wholesalers (distributors). The costs included for manufacturers, however, are different from the costs for retailers and wholesalers. You also need to understand the regulatory and tax issues related to inventory valuation.FIFO is the more straightforward method to use, and most businesses stick with the FIFO method.

Industry, regulatory and tax considerations

Accountants use “inventoriable costs” to define all expenses required to obtain inventory and prepare the items for sale. For retailers and wholesalers, the largest inventoriable cost is the purchase cost.

On the other hand, manufacturers create products and must account for the material, labor, and overhead costs incurred to produce the units and store them in inventory for resale.

You should also know that Generally Accepted Accounting Principles (GAAP) allow businesses to use FIFO or LIFO methods. However, International Financial Reporting Standards (IFRS) permits firms to use FIFO, but not LIFO. Check with your CPA to determine which regulations apply to your business.

Lastly, the inventory method you choose may impact your income tax liability. To explain, assume that Sterling sells 300 shirts on December 31st, 2021.

The FIFO and LIFO compute the different cost of goods sold balances, and the amount of profit will be different on December 31st, 2021. As a result, the 2021 profit on shirt sales will be different, along with the income tax liability. Again, these are short-term differences that are eliminated when all of the shirts are sold.

FIFO is the easiest method to use, regardless of industry, and this inventory valuation method complies with GAAP and IFRS. Use the FIFO method for your inventory transactions.

Accounting for inventory is essential—and proper inventory management helps you increase profits, leverage technology to work more productively, and to reduce the risk of error.

Final thoughts

The FIFO and LIFO methods impact your inventory costs, profit, and your tax liability. Keep your accounting simple by using the FIFO method of accounting, and discuss your company’s regulatory and tax issues with a CPA.

Use QuickBooks Enterprise to account for inventory using less time and with more accuracy. QuickBooks allows you to use several inventory costing methods, and you can print reports to see the impact of labor, freight, insurance, and other costs. With QuickBooks Enterprise, you’ll know how much your inventory is worth so you can make real-time business decisions.