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FIFO and LIFO are the two most common inventory valuation methods. FIFO stands for “first in, first out” and assumes the first items entered into your inventory are the first ones you sell. LIFO, also known as “last in, first out,” assumes the most recent items entered into your inventory will be the ones to sell first. The inventory valuation method you choose will depend on your tax situation, inventory flow, and recordkeeping requirements.
Inventory can be one of the largest assets in your small business. If your business has inventory, you probably already closely track the cost of your inventory. But do you pay the same amount of attention to how your inventory is valued?
There is more to inventory valuation than simply entering the amount you pay for your inventory into your accounting software. There are a number of ways you can value your inventory, and choosing the best inventory valuation method for your business depends on a variety of factors. In this FIFO vs. LIFO comparison, we’ll focus on the two most common inventory valuation methods and how to decide which one to use for your business.
There are five ways in which a business can choose to calculate the cost or value of inventory:
There is no wrong method to use to value your inventory, but there is a best way for your business. The method you choose depends on four different factors:
Let’s say you own a craft supply store specializing in materials for beading. Your inventory doesn’t expire before it’s sold, and so you could use either the FIFO or LIFO method of inventory valuation.
Over the course of the past six months, you have purchased spools of wire as follows:
You have purchased a total of 140 spools of wire during this period. You conduct a physical inventory and determine you have sold 120 spools of wire during this same period.
Regardless of the price you paid for your wire, you chose to keep your selling price stable at $7 per spool of wire.
Since you kept your price stable at $7 per spool of wire, you know your gross revenue was $840 ($7 x 120 spools). But what is your profit?
If you use the FIFO method of inventory valuation, you assume your oldest spools of wire were sold first. This means your costs are as follows:
Since you purchased 140 spools and sold 120, this table doesn’t include the 20 spools you purchased in June at $5 per spool, since these were the last in. Per the FIFO method, the first spools you purchased were the first out, meaning the last spools you purchased in June still remain in your inventory.
Your profit over the past six months is calculated as follows:
Gross Revenue – Cost of Goods = Gross Profit
$840 – $340 = $500
Your profit for the wire is $500.
Now let’s see what your profit is if you use the LIFO inventory valuation method. Your gross revenue is still $840, but how will your profit change by choosing a different valuation method?
Your profit over the past six months is calculated by the LIFO method as follows:
$840 – $380 = $460
Your profit for the wire is $460—$40 less than under the FIFO method.
A $40 profit differential wouldn’t make a significant difference to your bottom line. For the sake of simplicity, we kept the numbers in the example small. Also, we only looked at one item in your entire inventory. But you can easily see that—if the dollar amounts or the quantities sold were higher, and you factor in the different products in your craft store—choosing LIFO over FIFO would have a significant impact on your business’s profitability.
Of course, you want your business to be profitable. However, you also don’t want to pay more in taxes than is absolutely necessary. You neither want to understate nor overstate your business’s profitability. This is why choosing the inventory valuation method that is best for your business is critically important.
The IRS knows business owners want to minimize their tax burden. In order to keep taxpayers from gaming the system by valuing their inventory on a FIFO basis one year and LIFO the next, there are rules in place regarding inventory valuation:
Tax impact isn’t the only consideration when choosing your inventory valuation method. As mentioned earlier, inventory flow, recordkeeping, and reporting requirements also play a role in your inventory valuation method. When deciding whether FIFO vs. LIFO is right for your business, consider these factors as well:
For spools of craft wire, you can reasonably use either LIFO or FIFO valuation. For perishable goods—like groceries—or other items that lose their value with time, using LIFO valuation doesn’t make sense because you will always try to sell older inventory first.
If you choose to use the LIFO method of inventory valuation, you will need a recordkeeping system that allows you to determine when you access older “layers” of inventory, and then apply the cost of that older inventory accurately. Many businesses find this requirement alone negates any benefits of LIFO valuation.
If you are looking to do business internationally, you must keep IFRS requirements in mind. LIFO valuation is not allowed under these standards. If you plan to do business outside of the U.S., choose FIFO or another inventory valuation method instead.
As we’ve explored here, there are a number of factors that impact which inventory valuation method you should use. Tax considerations play a large role in your choice, but tax impact shouldn’t be the only thing you consider when choosing between FIFO and LIFO.
Although FIFO is the most common and trusted method of inventory valuation, don’t default to using FIFO. In certain cases, LIFO might be the better choice. Discuss your inventory valuation options with your accountant. He or she will be able to help you make the best inventory valuation method decision for your business based on your tax situation, inventory flow, and recordkeeping requirements.
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