Today we’ll be discussing the differences between LIFO (last-in, first-out) and FIFO (first-in, first-out). Each of these are specific inventory management styles that allow warehouses to prioritize what they will sell and when.
In some cases, these inventory styles will fit specific industries better than others. We’ll break down each of them so that you can have a good idea of what works best for your industry and how to implement the system well.
The LIFO method uses the practice of taking the items that were last received into your warehouse and selling them or shipping them first. So, selling or shipping the newest, most recent items first.
When using the LIFO method, you’ll more easily be able to manipulate financial statements and tax documents in your favor. While you’ll still end up paying the same amount in taxes eventually, you might be able to save money in the short term. Financial statements are more positively affected because you can use the most recent inventory cost first. If you’re able to acquire the latest inventory for cheaper, you’ll be able to pay less in taxes overall.
When using FIFO, you’ll have to more accurately display what you paid for the oldest inventory, whether that be more or less. Profits will often seem higher when using FIFO, which is more attractive to investors.
Pros of LIFO
- A higher cost of goods sold, lower profits, less tax liability with inflation.
- During deflation, lower cost of goods sold, higher profits, and higher tax liability.
- More profits and more appealing to investors during deflation.
Cons of LIFO
- More complex to understand.
- Older inventory items may cause costs of goods sold to fluctuate when sold at a later date.
- Not compatible with the IFRS (International Financial Reporting Standards) accounting method.
- Lower earnings which can discourage investors.
As you can see, there are quite a few variables that determine whether your warehouse will see success using the LIFO to manage inventory within the warehouse. Making a good profit by selling the most recent stock first, will primarily depend on whether the economy is in a time of inflation or deflation. During deflation, LIFO can make your warehouse extremely profitable, but you could potentially lose money during inflation. LIFO is by far a much more significant risk to your bottom line.
The FIFO method is opposite to LIFO in that, the items that have been in your warehouse the longest would be sold first. This is a standard method at grocery stores and other similar suppliers where products will deteriorate or expire with age. It could be summed up as selling or shipping the oldest items first before any newer items.
The FIFO method is by far much easier to understand and implement as a company. There are fewer variables, and in general, most businesses are already selling and shipping their inventory in this way. Additionally, it’s the best way to calculate COGS (costs of goods sold). Accurately conducting inventory counts and regularly tracking COGS is critical to filing income taxes. This is because FIFO simply follows the natural flow of inventory.
Pros of FIFO
- Compatible with both IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles).
- Low complexity and easy to understand.
- Minimal to no fluctuation in COGS.
- During inflation—lower cost of goods sold, higher profits, greater tax liability, and higher earnings with more appeal to investors.
Cons of FIFO
- During deflation—higher cost of goods sold, lower profits, less tax liability, and lower earnings with less appeal to investors.
The FIFO method will help you to maximize profits on your inventory without having to risk as many variables. As you’d probably guess, based on the pros and cons, FIFO makes sense for many more business models and is seen to be more of an industry standard. Additionally, if you ever expand your business internationally, FIFO is more broadly accepted as a way to determine net income.
How to Calculate COGS with Each Method
Calculating COGS is critical to having a successful business. To help you have a better understanding of how these different methods work, here are examples of how to calculate the costs of goods sold.
LIFO – to calculate COGS with the LIFO method, determine the cost of your most recent inventory and multiply that by the amount of inventory sold.
FIFO – to calculate COGS with the FIFO method, determine the cost of your oldest inventory and multiply that by the amount of inventory sold.
After you have those numbers, there are just two steps left. First, account for price fluctuations to develop an average. And secondly, be sure to remove any inventory that hasn’t yet been sold. You can’t account for inventory that hasn’t been sold.
LIFO vs FIFO
So, the question remains, which system is a better accounting method? The answer, unfortunately, isn’t simply one or the other. It really depends. If you’re new to the industry, we’d strongly suggest that you do some more research on the topic and encourage you to start with the more simple, FIFO. But, more experienced business owners and operators might take the calculated risk of trying the LIFO method. While LIFO does propose more risk out of the two accounting methods, a company that uses it on the right product at the right time can do really well.
Industries That Use LIFO
Here are some of the industries that often use the LIFO method:
- Automotive industries when needing to quickly ship.
- Petroleum-based production companies.
- Pharmaceutical industries with some products.
Industries That Use FIFO
Here are the industries that often use the FIFO method:
- Grocery Stores
- When inventory is perishable or expires.
- Companies that need to make sure they don’t have old inventory.
Ultimately both of these accounting methods will work better when paired with top-notch inventory management software. A system like topShelf from Scout will help you keep track of inventory as it comes in the door and, in turn, accurately pick, pack, and ship. To learn more about topShelf, reach out to Scout today!
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