FIFO assumes that the first items placed into inventory are the first items to be sold. This means that when calculating COGS, the cost of the oldest items in inventory is used. This method is used when prices are expected to increase, as it results in a lower COGS and therefore a higher gross profit. I have built a FIFO inventory calculator in Excel here.
LIFO, on the other hand, assumes that the last items placed into inventory are the first items to be sold. This means that when calculating COGS, the cost of the most recent items in inventory is used. This method is used when prices are expected to decrease, as it results in a higher COGS and therefore a lower gross profit.
Both FIFO and LIFO have their advantages and disadvantages, and the choice between them depends on the specific circumstances of the business and the market conditions. It is important to carefully consider which method is the most appropriate for your business.
There are several factors that you should consider when deciding whether to use FIFO or LIFO for inventory accounting:
- Market conditions: If prices are expected to increase, FIFO may be the better choice as it results in a lower COGS and therefore a higher gross profit. If prices are expected to decrease, LIFO may be the better choice as it results in a higher COGS and therefore a lower gross profit.
- Inflation: FIFO is generally more accurate in inflating environments because it reflects the current cost of goods. LIFO, on the other hand, may result in a lower COGS and therefore a higher gross profit, but it may not accurately reflect the true cost of goods in an inflating market.
- Tax implications: The choice between FIFO and LIFO can also have significant tax implications. In general, LIFO can result in a lower taxable income, as it results in a higher COGS and therefore a lower gross profit. This can be beneficial for businesses that are subject to high tax rates.
- Financial statements: The choice between FIFO and LIFO can also affect the appearance of a company's financial statements. FIFO generally results in higher inventory values, while LIFO results in lower inventory values.
It is important to carefully consider all of these factors when deciding which inventory accounting method is the most appropriate for your business. Also, when you choose a methodology, be prepared to stick with it.
Can You Change Your Inventory Accounting Method?
Once you choose LIFO or FIFO, you are generally required to consistently use that method for all of your inventory items. It is important to choose a method that accurately reflects the physical flow of your inventory, as well as one that aligns with your business goals and financial reporting requirements.
It is also worth noting that you may be required to obtain permission from the Internal Revenue Service (IRS) to change your inventory accounting method, and the IRS may require you to show that the change is necessary and reasonable. Additionally, changing your inventory accounting method can have tax implications, so it is important to carefully consider the potential impact on your business before making a change.
Article found in Accounting and Finance.
