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Good financial management isn’t just about keeping track of your company’s cash flow. It’s also about tracking the value of your non-liquid assets. Assets that are bought, acquired, sold, used, or disposed of are all included in a company’s valuation. The costs associated with these assets need to be properly accounted for in order to determine the profit associated with the sale of each asset.
Proper asset management ensures that business leaders can account for assets such as inventory, raw materials, equipment, machinery, and real estate as they pass into and out of their companies. When preparing their income statement for tax purposes, business leaders will notice that the value of assets, when sold or disposed of, is less than when they were bought or acquired. The same items may also be purchased at different times throughout the year at varying prices due to inflation. As such, cost flow assumptions need to be incorporated into the company’s asset management.
One accounting method to aid in this is known as the first in, first out, or FIFO method.
First in, first out (FIFO) definition
First in, first out (FIFO) is an inventory valuation method where what the company buys, produces, or acquires first is also used or disposed of first.
FIFO assumes that inventory assets with the oldest costs are included in the cost of goods sold (COGS). Because these older expenses are lower, the result is a higher net income on the company’s financial statements. Since newly acquired inventory is purchased at a higher price, this could result in a higher final inventory balance.
FIFO can be useful for sectors like manufacturing, where materials move through different development stages and are sold as finished items. The costs associated with inventory assets are listed as expenses on the company’s balance sheet.
Example of FIFO in practice
Now that we know how the FIFO inventory method works in theory, let’s look at it in practice.
A car dealership buys inventory
- The business buys 10 cars at $10,000 each in January, then 10 more in February at $15,000 each.
- Of these 20 cars, the company sells 10. Selling 10 items under FIFO means a COGS of $10,000 per unit for the first 10 items sold because the company sells the 10 cars purchased in January first because they were acquired before the second batch of cars in February.
- The value of the 10 remaining cars is $15,000 per unit. Since the older batch of 10 units sold, the unit price will now be $15,000 rather than $10,000 per unit
Costs are assigned to inventory items as they are prepared for sale. These might include the purchase cost of raw materials, labor costs, and production costs. Under FIFO inventory management systems, costs are based on which items arrived first.
Another accounting method to consider is LIFO method, also known as last in, first out.
What is the definition of last in, first out (LIFO)?
Last in, first out is used to calculate the value of inventory, where the most recently purchased inventory will be the first sold. It is most commonly used by companies that have large and high-cost inventories and higher cash flows.
The United States is one of the only jurisdictions in which LIFO accounting can be used.
Example of LIFO in practice
Now we know a little about the theory of the LIFO system for inventory value calculation. But what might this look like in the real world of business?
A dealership buys cars in batches
- Batch 1: The dealership buys five cars of the same make and model for $10,000 per vehicle. This batch arrives in January.
- Batch 2: The dealership buys five cars of the same make and model for $15,000 per vehicle. This batch arrives in February.
- The dealership sells 8 cars.
If all eight cars in this example are sold at the same price, they would have different COGS associated with them depending on which batch they were in. Under LIFO, we assume that the last vehicles acquired were the last vehicles sold, so if all five vehicles from batch two were sold, while three vehicles from batch one were sold at the same price. Last in becomes first out.
As such, the COGS is $105,000 (five at $15,000 and three at $10,000) under the LIFO system. If, on the other hand, the same company carried out the exact same transaction and used the first in, first out /FIFO system, the cars costing $10,000 apiece would be sold first, followed by three of the vehicles that cost $15,000 each. This would change the total cost of goods sold to $95,000.
LIFO versus FIFO: Which is better for your small business?
As we can see, LIFO is an accounting tool that may be apt for particular businesses or under specific circumstances. While FIFO is a good all-rounder when it comes to inventory management, there may be some circumstances where LIFO is a better fit for your operations.
Below are some advantages and disadvantages of using the FIFO method versus the LIFO method:
Pros and cons of the FIFO method
|
FIFO advantages |
FIFO disadvantages |
|
Simple to understand and implement |
Discrepancies between costs and revenue may artificially inflate gross profits |
|
Generally reflects the natural flow of inventory |
The business could pay more in income tax |
|
May be required by accounting standards in some jurisdictions |
Pros and cons of the LIFO method
|
LIFO advantages |
LIFO disadvantages |
|
May lower tax liability due to higher COGS |
More complex and less intuitive |
|
Fewer inventory write-downs |
Older items in inventory can cause COGS to fluctuate |
|
Permissible in U.S. under GAAP standards |
Lower reported income and net worth could be discouraging to investors |
|
Can be advantageous to businesses that use the cash accounting method |
Not permissible under IFRS |
When it comes to getting a clear picture of their companies’ finances, business leaders need to think beyond cash flow. Liquidity is important, especially to SMBs in their early years, but the value of a company extends far beyond its liquid assets. When preparing their financial statements either for tax purposes, external valuation, or internal review, businesses need to have a clear picture of how much of the company’s value is held as inventory.
Alternatives to FIFO and LIFO
The FIFO method is inherently in line with many business practices. Most businesses want to sell older inventory items first and hold onto newer items to avoid obsolescence, and items sold may have expiration dates because they are perishable. However, the inventory valuation method a company uses does not always follow the actual flow of inventory through the company. LIFO is a fairly idiosyncratic inventory valuation method that may be beneficial for some companies under the right circumstances. Here are other inventory valuation methods to consider:
Average cost method
When using the average cost inventory method, the same cost is assigned to every inventory item. An average cost calculation is achieved by dividing the cost of goods in inventory by the total number of items that are ready for sale. As a result, net income and ending inventory balances are usually somewhere between those for FIFO and LIFO.
Specific inventory method
Specific inventory tracking can be employed when a company knows the value of all components that are attributable to a finished product. However, this involves a level of granular reporting that not all businesses and accounting software platforms can manage easily. Therefore, alternatives like FIFO and LIFO are appropriate to assume inventory costs.
Choosing the right inventory valuation method depends on your business’ specific needs and circumstances. FIFO is generally a good pick in most cases, while LIFO can be advantageous in certain conditions, like steep cost increases or non-perishable inventory. Understanding these methods helps in making informed decisions for effective financial management.
