Inventory represents the largest asset of any product-oriented business. That’s why inventory management is so important, because the way you value your inventory has profound effects on your taxes, income, logistics, and profitability. LIFO and FIFO are the most common methods of inventory valuation for product-oriented businesses.
Though each has its pros and cons, an understanding of how FIFO and LIFO work with your inventory accounting system will help you decide which method is best for your business.
Understanding Inventory Accounting
According to the Tax Cuts and Jobs Act (effective 2018), a small business can treat inventory as “non-incidental materials and supplies”, meaning that the items are bought for resale. But to do so, you must utilize an accounting method that clearly reflects income.
In other words, if you keep inventory, the IRS requires that you use accrual accounting methods, in which revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
Since inventory is constantly moving in and out of a company, the cost of individual inventory items can be difficult to track. Thus, Generally Accepted Accounting Principles (GAAP) allow a business to use one of three inventory accounting methods:
- first-in, first-out (FIFO),
- last-in, first-out (LIFO), and;
- average cost.
Of the three, FIFO and LIFO are the most common valuation methods used by product-based businesses, like retailers and online stores. To determine which is best for your business, you need to know the key differences between FIFO and LIFO, and how each affects your recordkeeping.
LIFO vs. FIFO: What’s the Difference?
The first in, first out (FIFO) inventory management system is most commonly used by businesses carrying physical inventory, and operates under the assumption that the first items added to inventory will be the first ones sold. Conversely, LIFO assumes the last items placed in inventory will be the first to be sold.
Though the names are self-explanatory, the method you choose will directly affect key financials, like balance sheets, and cash flow statements. In most cases, FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.
LIFO, on the other hand, is only strategically valuable during times of inflation, as goods sold first are also typically the most expensive. This increases the cost of goods sold, and reduces profits, which also reduces income tax liability.
In other words, using the more expensive products first lowers net income, which lowers profits, which means your business will have a lower taxable income. Though LIFO is rarely used, it remains a valuable strategic tool for businesses looking to optimize their cost of goods sold, and ending inventory.
A Note on the Average Cost Method (ACM)
Some businesses seek to balance LIFO and FIFO by using the average cost method of inventory cost accounting. Under ACM, the weighted average cost of all available inventory items for a given accounting period is used to calculate both COGS and ending inventory.
Advantages and Disadvantages of FIFO vs LIFO
Most companies naturally prefer the FIFO inventory accounting method over LIFO because there is typically no valid reason to use recent inventory first, while leaving older inventory to age on the shelf. This is particularly true of perishable items, and items that rapidly become obsolete.
Though FIFO is more appealing to companies looking to bolster their attractiveness to investors and lenders. LIFO can appeal to companies looking to reduce their tax liability, and may be a better choice in certain scenarios, such as:
- businesses with steeply rising costs – Supermarkets and pharmacies typically use LIFO because their products are sensitive to inflation.
- companies that use physical LIFO – Certain industries, like lumber and mining, stack the newest inventory items on top of older ones.
- businesses that face inventory write-downs during inflation – Examples include the fashion and agricultural industries that carry inventory that spoils, is easily damaged, or is vulnerable to obsolescence.
- seasonal businesses – It’s important for seasonal businesses to conserve cash during the off season. LIFO enables a company to reduce its tax liability, thereby allowing a them to keep more cash.
Ultimately, the choice between FIFO and LIFO inventory accounting methods will be based on the needs of your business, and how it operates.
FIFO Vs LIFO: Which is the Best Inventory Valuation Method for Your Business
If you sell products, inventory management is a necessity. Deciding whether to use LIFO or FIFO can be complicated, so be sure to consider both options carefully before making a decision.
Either way, you’ll need a warehouse solution to keep your inventory costs under control, your balance sheet in order, and your tax situation in your favor. If you’re still manually tracking inventory, now’s the time to make the move to Flowspace.