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LIFO vs. FIFO: Understanding the Difference

written by: Aunindita•edited by: Linda Richter•updated: 4/3/2013

LIFO vs FIFO is a complex topic. This article will look at their similarities and differences in an attempt to help you choose which one is right for your business.

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    What are LIFO and FIFO?

    Before we get into the discussion of LIFO vs FIFO, let us describe briefly what they are. LIFO and FIFO are two of the ways to manage and account for cost of inventory. They are used to create the Cost of Goods (COGS) part of a company’s income statement.

    LIFO stands for Last In First Out and FIFO stands for First In First Out. That means with FIFO the oldest inventory items are recorded as sold first while the LIFO accounting method records the most recently purchased items as sold first. In the choice of LIFO vs FIFO, since the 1970s many companies–especially in the United States–have chosen to use LIFO, mainly because it reduces income taxes during periods of inflation.

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    Similarities & Differencees

    There really aren’t any similarities between LIFO and FIFO. They are basically two different inventory management techniques. One thing that can be said about LIFO and FIFO is that both methods only work if the product remains the same–the only change is the cost of the product. If you need help in deciding LIFO vs FIFO, you need to look at the differences.

    LIFO and FIFO affect a company’s earnings in different ways. Let’s start off by looking at one month of balance sheet using the FIFO method. Let’s say that at the beginning of the month you have 30 of a particular product that costs you $20. Then you receive another 50 of the product at a slightly higher price, $21 dollars. After you have your product, an order is placed for 40 of them. With FIFO, you sell all 30 of your starting inventory and 10 from the second group you received. To figure out the cost of sales, you multiply 30 times $20 dollars and add to it 10 times $21. That would be a total of $810.

    Now take the same situation and apply the LIFO accounting method. According to LIFO, the order for 40 of your product is filled using only the newest product you received. $21 multiplied by 40 is $840. A difference of 6.5 percent ($30) between the two methods may not seem like much in this example, but when you are talking about moving hundreds or thousands of products a month over the course of a year–it adds up.

    LIFO allows you to account for the current cost of your inventory. This is important at tax time during periods of inflation. While FIFO generally results in higher earnings, it also generates higher taxes. The earnings after-tax are lower. With LIFO the earnings, and therefore the taxes, are lower. This results in a higher earning after taxes.

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    Which One is Right?

    If the price of your product remains steady, than FIFO is a good choice. Further discussion of LIFO vs FIFO and which one is right for you first requires a thorough analysis of your business.

References

  • Image Credit: webpages.csus.edu/~jg733/images/AccountingPic%5B1%5D.jpg
  • Image Credit: http://img.directindustry.com/images_di/photo-g/flow-storage-shelving-391788.jpg
  • Image Credit: tutorsonnet.com/basicaccounting.jpg