FIFO, which stands for "first-in-first-out," is an inventory costing method which assumes that the first items placed in inventory are the first sold. Thus, the inventory at the end of a year consists of the goods most recently placed in inventory. FIFO is one method used to determine Cost of Goods Sold for a business .
LIFO, which stands for "last-in-first-out," is an inventory valuation method which assumes that the last items placed in inventory are the first sold during an accounting year. Thus, the inventory at the end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the end. LIFO is one method used to determine Cost of Goods Sold for a business. LIFO accounting is only used in the United States.
Here is how inventory cost is calculated using the LIFO method:
Assume a product is made in three batches during the year. The costs and quantity of each batch are:
- Batch 1: Quantity 2,000 pieces, Cost to produce $8000
- Batch 2: Quantity 1,500 pieces, Cost to produce $7000
- Batch 3: Quantity 1,700 pieces, Cost to produce $7700
- Total produced: 5,200 pieces. Total cost $22,700. Average cost to produce one piece: $4.37.
Next, you must calculate the unit costs for each batch produced.
- Batch 1: $8000/2000 = $4
- Batch 2: $7000/1500 = $4.67
- Batch 3: $7700/1700 = $4.53
Let's say you sold 4,000 units during the year, out of the 5,200 produced. You don't know which pieces at which cost were sold. To determine the cost of units sold, under FIFO accounting, you start with the assumption that you have sold the oldest (first) produced produced items first.
So, of the 4,000 units sold, using FIFO
You assume that batch 1 items were sold first. So, The first 2,000 units sold from Batch 1 cost $4.00 per unit. That's a total of $8,000.
- The next 1,500 units sold from the second batch cost $4.67 per unit, for a total of $7005.
- And the last 500 units sold from the third batch cost $4.53 each, for a total of $2,265.
Adding these costs together, the total cost of the 4,000 items sold is $17,270.
The cost of the remaining 500 units from Batch 3 is $4.53 each, for a total cost of $2,265. The remaining inventory of 800 units at a total cost of $3,624 will start off the next year as beginning inventory.
This calculation is not exactly what happened, because in this type of situation it's impossible to determine which items from which batch were sold in which order. It's just a way to get a calculation.
Other inventory costing methods
Instead of using FIFO, some businesses use one of these other inventory costing methods:
- Specific identification is used when specific items can be identified. For example, the cost of antiques or collectibles, fine jewelry or furs, can be determined.
- LIFO costing ("first in, first out"), which considers the last produced products as being those sold first. In this case, you would assume that Batch 3 items would be sold first, then Batch 2 items, then the remaining 800 items from Batch 1 would be sold. The total cost of 4000 items sold under LIFO accounting would be $17,906. The cost of the remaining 500 items from Batch 1 at $4 each would total $3,200.
- Average cost is the overall average of the cost of all items. The total cost of 4,000 items sold at an average cost of $4.37 would be $17,461.53.
One reason for valuing inventory is to determine its value for inventory financing purposes.
Read more about FIFO and LIFO - What's the Difference? Which is Better?"