FIFO vs LIFO example

Introduction

This tutorial provides a comprehensive overview of the FIFO (First In First Out) and LIFO (Last In First Out) inventory accounting methods. Understanding these methods is essential for businesses managing inventory, as they can significantly affect the Cost of Goods Sold (COGS) and gross profit. By following this guide, you will learn how to implement both methods and understand their implications on financial statements.

Step 1: Understand FIFO and LIFO

• FIFO (First In First Out)

  • The oldest inventory items are sold first.
  • In periods of inflation, FIFO results in lower COGS and higher gross profit.

• LIFO (Last In First Out)

  • The most recently acquired inventory items are sold first.
  • In inflationary periods, LIFO results in higher COGS and lower gross profit.

Step 2: Visualize the Concepts

• Create a simple chart or table to visualize inventory flow.
• For FIFO:
  • Item A (100 units at $10) is sold first.
  • Then Item B (100 units at $12) is sold next.
• For LIFO:
  • Item B (100 units at $12) is sold first.
  • Then Item A (100 units at $10) is sold next.

Step 3: Perform a Numerical Example

1. Set Up Inventory Data

   • Assume you have the following inventory:
     • 100 units of Item A at $10 each
     • 100 units of Item B at $12 each

2. Record Sales

   • Suppose you sell 150 units.

3. Calculate COGS for FIFO

   • Sell 100 units of Item A: 100 x $10 = $1,000
   • Sell 50 units of Item B: 50 x $12 = $600
   • Total COGS (FIFO) = $1,000 + $600 = $1,600

4. Calculate COGS for LIFO

   • Sell 100 units of Item B: 100 x $12 = $1,200
   • Sell 50 units of Item A: 50 x $10 = $500
   • Total COGS (LIFO) = $1,200 + $500 = $1,700

Step 4: Analyze the Financial Implications

• Impact on Gross Profit

  • With FIFO, the gross profit would be higher due to lower COGS.
  • With LIFO, the gross profit would be lower because of higher COGS.

• Tax Implications

  • A higher gross profit under FIFO means higher taxes.
  • Conversely, lower profits under LIFO can result in tax savings.

Step 5: Review Common Pitfalls

• Ensure you consistently apply the same method throughout the accounting period.
• Be aware of the effects of inflation on your financial reports.
• Assess how changes in inventory methods might affect your financial statements.

Conclusion

In summary, choosing between FIFO and LIFO inventory methods can have profound effects on your business's financial outcomes. FIFO generally leads to lower COGS and higher profits, while LIFO can reduce taxable income during inflation. Carefully consider your business context and inventory management strategies when deciding which method to implement. For further assistance, consider exploring inventory management software such as InFlow to gain better visibility into your COGS and margins.