Inventory costing is an accounting concept which has a direct impact on your company’s gross profit and taxable income. Methods of valuing inventory are simply different cost-flow assumptions about how to allocate your cost of goods available for sale and each inventory valuation method has a different effect on your cost of goods sold and ending inventory value.
Today’s article, we are going to look at 2 methods of valuing inventory which are very common among companies worldwide: FIFO and LIFO.
LIFO, which stands for last – in, first – out, assumes that the last inventories bought are the first ones to be sold and that inventories bought first are sold last. Under LIFO, the cost of the most recent items purchased (or produced) which are the first to be expensed as cost of goods sold. When prices are rising, the ending inventory is valued lower at older costs, the cost of goods sold is higher and thus gross profit and taxable income are lower. That's to say, LIFO gives a higher cost to inventory. With the effects of inflation, recently acquired items are more expensive. This increases the cost of goods sold and decreases the net profit. Thus, the income tax is smaller and value of unsold inventory is lower.
LIFO method has those advantages:
Matching most recent costs against current revenues
Making tax benefits and improvement in cash flows
Minimizing write-downs to market
However, while LIFO is used in the United States, it is forbidden in other countries because it has the effect of depressing gross profits and taxable income.
FIFO, which stands for first – in, first – out, assumes the opposite that you will sell the oldest goods in your inventory first. When costs are increasing, the products acquired first were cheaper. This decreases the cost of goods sold under FIFO and increases profit stimulately. Therefore, the income tax is larger and value of unsold inventory is also higher. In other words, only the newest items remain in the inventory and the cost is more recent, hence there is no unusual fluctuation in cost of goods sold.
The FIFO method is the standard inventory method for most companies and there are no GAAP and IFRS restrictions for using this accounting method. It is very common to use the FIFO if your business’s trades are in foodstuffs and other goods that have a limited shelf life because the oldest goods need to be sold before they expire.
3. Which method is better?
It depends much on your type of business to assess the relative value of LIFO and FIFO inventory cost. For example, if you run a retail business selling artisanal wines, LIFO method is fine because your products no need selling soon but it becomes better when staying in warehouse for such a long time. However, if you work for a computer Inc., it is crucial to use FIFO because technology is out of date in short term.
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