Around the end of a business's fiscal (financial) year, auditors and accountants start to talk about "taking inventory" and "LIFO vs. FIFO." But what's the difference between these terms, and which one is better for my business? This article looks at inventory in general and FIFO and LIFO as the two most common methods to value inventory.Let's start with the basics and keep things simple: Companies that are producing products for sale, or who have purchased products from a wholesaler to re-sell have inventory (a supply of unsold products). Inventory is an asset, since it has a value. At the end of the year each company must determine the cost of all the products in inventory in order to calculate cost of goods sold (COGS). Cost of goods sold is calculated as:
- Beginning inventory
- Plus purchases to inventory
- Less ending inventory
- Equals cost of goods sold.
Read more about cost of goods sold
Inventory Valuation Methods - FIFO, LIFO, Specific Value, and Weighted Average
Since inventory is constantly coming into and going out of a company, it's difficult to keep track of the cost of inventory, so a generally accepted accounting principle allows businesses to use some general guidelines in valuing the cost of inventory:
- Specific Value Some types of products can be valued individually and a specific value assigned. For example, antiques, collectibles, artwork, jewelry and furs, can be appraised and a value assigned. The cost of these items is typically the cost to purchase, so the profit can easily be determined.
- First-in, First-out (FIFO):Under FIFO, it's assumed that the inventory that is the oldest is being sold first. The FIFO method is the standard inventory method for most companies.
- Last-in, First-out (LIFO): LIFO is a newer inventory cost valuation technique (accepted in the 1930s), which assumes that the newest inventory is sold first.
- Average cost, which just takes the average cost of inventory sold.
Which is Better - LIFO or FIFO?
To assess the relative value of LIFO and FIFO inventory cost, you need to look at the way your inventory costs are changing:
- If your costs are going up, or are likely to increase, LIFO costing may be better, because the higher cost items (the ones purchased or made last) are considered to be sold. This results in higher costs and lower profits.
- If the opposite it true, and prices are going down, FIFO costing might be better. Since prices usually increase, most businesses prefer to use LIFO costing.
- FIFO costing results in a more accurate cost because older items are most usually sold first.
Record keeping issues
LIFO inventory accounting increases record keeping, because older inventory items may be kept on hand for several years, while under FIFO those older items are sold first, so record keeping requirements are less.
Regulations and FIFO vs. LIFO
As you might guess, the IRS doesn't like LIFO valuation, because it usually results in lower profits (less taxable income). But the IRS does allow businesses to use LIFO accounting, requiring an application, on Form 970. Read more about the IRS's thoughts on LIFO.
The national accounting standards organization, the Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting. The international accounting standards body (IFRS) doesn't allow LIFO to be used, so if your company has international locations, you probably won't be able to use it.
Restrictions on Changing Inventory Methods
If your business decides to change to LIFO accounting from FIFO accounting, you must file Form 970 with the IRS, and you will not be allowed to go back to FIFO accounting unless the IRS gives specific permission.
Talk to an advisorThe information in this article and on this site is intended to be general and not for the purpose of giving tax or legal advice. The decision to change inventory methods or to change back is complicated and has many tax and accounting implications. Talk to your CPA and tax advisor and get opinions on your specific business situation before you attempt to make a change.
Read more about how to make your inventory work for you, from Rosemary Peavler, About.com's Guide to Business Finance.