Today we are going to talk about the difference between LIFO and FIFO. Watch now!
VIDEO SUMMARY
In last week’s video, I mentioned LIFO very briefly. I wanted to talk about LIFO in more detail, because there are some important accounting ideas you need to understand.
Definition
Let us start with the definition. What is LIFO and FIFO? LIFO stands for Last In First Out, and FIFO stands for First In First Out. These are the most common methods of inventory valuation. There are actually many more methods, but these are the most common. LIFO is only allowed in the United States, because GAAP accounting standards allow LIFO, whereas international accounting standards do not.
LIFO and FIFO really deal with time. You create a set of financial statements at a moment in time, but you purchase inventory many different times. You need to figure out your Cost of Goods Sold (COGS). LIFO means the most recent purchases are sold first. FIFO is the opposite, where you sell the oldest items first.
Example
Inflation is the reason LIFO and FIFO are important. We all know that prices tend to increase over time. Prices do not always go up, but that is the general trend. Let us look at an example. Imagine you purchase inventory a year ago at $1 per item for 50 items and you purchase again at the end of the year at $2 per item for 50 items. At year-end, you create your financial statements and find you sold 50 items total at $4 per item. Now you have a choice. You had 100 items and you sold 50, but which 50? Did you sell the 50 at $1 per item or $2 per item? LIFO says you sold them for $2 for a profit of $2, and FIFO says you sold them for $1 for a profit of $3. If there is no inflation, and no change in prices, LIFO and FIFO are the same. However, there are usually changes in price, which creates this problem.
Key Concept
The key concept you should understand is that inventory is an estimate. When you look at your financial statements, the number for inventory is not an exact value. There are different methods for calculating that number, and they all result in different amounts. Since we have alternate methods of valuation, LIFO and FIFO are not explaining what actually happened to your bank account, it is just how you report it. In your bank account, cash went out when you made the purchase, cash came in when you sold it, and some value remains for your current inventory. LIFO and FIFO determine that value.
The problem with LIFO
The problem with LIFO is that over long periods, LIFO skews your inventory number. Imagine you are always selling your most recent purchases. Your older purchases can sit on your balance sheet for years. If you are in business for 10 years, your inventory number may not reflect what you actually have in stock. Under FIFO, your balance sheet number is more accurate because your inventory includes your most recent purchases.
The benefit of LIFO
There are also benefits to LIFO. I have mentioned before that LIFO often reduces your taxes. If prices are increasing over time, you count the highest priced items as sold first, which reduces your reported profit. This reduces your taxes. Remember that what you report does not affect what actually happened to your cash. So under LIFO, nothing about your situation actually changes, you just owe less taxes.
Another benefit of LIFO is that your income statement is more accurate. We are spending all this time discussing inventory, but inventory is not really what is important. What investor’s really care about is your gross margin ratio. Your gross margin ratio is profit divided by sales. In other words, if I invest in your company to grow sales, how much profit am I going to get?
The Example Continued
Let us return to the earlier example. Under LIFO, your profit was $2 on sales of $4. Under FIFO, your profit was $3 on sales of $4. LIFO has a gross margin ratio of 50%, whereas FIFO has a gross margin ratio of 75%. This tells you that for every $1 in sales you are either getting $.50 or $.75 in profit. The difference is that one number is based off prices from one year ago. This is important because it is telling me that my margins are shrinking. The argument for LIFO is that you want this information to be based on what is currently going on in the market, not on old prices from a year ago. That could impact your investment decisions. This is a huge argument in favor of using LIFO.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.