How to Calculate FIFO and LIFO Costing Methods
Master FIFO and LIFO inventory costing methods. Learn practical calculations and understand their significant influence on your financial reporting.
Inventory represents a significant asset for many businesses, impacting both operational efficiency and financial reporting. Managing this asset effectively requires assigning costs to inventory items, a process that becomes particularly important when the cost of acquiring goods fluctuates over time. Inventory costing methods provide a structured approach to valuing the goods a business holds and sells. Two widely used methods for this purpose are First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). These methods help businesses determine the cost of goods sold and the value of remaining inventory, influencing key financial metrics.
Understanding Inventory Costing Methods
The First-In, First-Out (FIFO) method assumes the first goods purchased or produced are the first ones sold. Costs of the oldest items are expensed first when a sale occurs. A grocery store selling oldest produce first aligns with FIFO. This method often reflects the physical flow of inventory for many businesses, especially those dealing with perishable goods.
Conversely, the Last-In, First-Out (LIFO) method assumes the most recently purchased inventory items are the first ones sold. Costs of the newest goods are expensed as cost of goods sold. Though it may not mirror physical movement, it is permitted for accounting in the United States. A company might use LIFO for accounting even if physical inventory management follows FIFO. This method essentially matches the most recent costs against current revenues.
Calculating Inventory Costs Using FIFO
The FIFO method calculates inventory costs by identifying the earliest unit costs for Cost of Goods Sold (COGS) and the latest unit costs for ending inventory. It assumes sold items are drawn from the oldest stock. This approach often aligns with the natural flow of inventory for many businesses.
To illustrate, consider a business with the following inventory transactions:
Beginning Inventory: 0 units
January 5: Purchased 100 units at $10.00 per unit
January 15: Purchased 150 units at $12.00 per unit
January 20: Sold 80 units
January 25: Purchased 120 units at $13.00 per unit
January 30: Sold 200 units
For the January 20 sale of 80 units: Under FIFO, these units come from the earliest purchase. The 80 units are costed at $10.00 each, resulting in a COGS of $800 (80 units $10.00/unit). After this sale, 20 units remain from the January 5 purchase (100 – 80), and all 150 units from January 15 remain.
For the January 30 sale of 200 units: First, draw from the remaining oldest units: 20 units from January 5 at $10.00 per unit, totaling $200. The remaining 180 units (200 – 20) come from the January 15 purchase: 150 units at $12.00 per unit, totaling $1,800. The remaining 30 units (180 – 150) come from the January 25 purchase: 30 units at $13.00 per unit, totaling $390.
The total COGS for the January 30 sale is $200 + $1,800 + $390 = $2,390. The total COGS for the period is the sum of both sales: $800 (January 20) + $2,390 (January 30) = $3,190.
To determine ending inventory value, identify remaining units and their costs. After the January 30 sale, 90 units remain from the January 25 purchase (120 – 30), which are the most recently purchased. Ending inventory is valued at $1,170 (90 units $13.00/unit). This reflects current costs on the balance sheet, as older, lower-cost items are assumed sold.
Calculating Inventory Costs Using LIFO
The LIFO method calculates inventory costs by assuming the most recently purchased units are sold first, affecting Cost of Goods Sold (COGS) and ending inventory differently from FIFO. This method matches current revenues with the most recent costs incurred. While not always reflecting the physical flow of goods, LIFO is a permissible accounting method in the United States.
Using the same example transactions:
Beginning Inventory: 0 units
January 5: Purchased 100 units at $10.00 per unit
January 15: Purchased 150 units at $12.00 per unit
January 20: Sold 80 units
January 25: Purchased 120 units at $13.00 per unit
January 30: Sold 200 units
For the January 20 sale of 80 units: Under LIFO, these units come from the most recent purchase. The 80 units are costed from the January 15 purchase at $12.00 per unit, resulting in a COGS of $960 (80 units $12.00/unit). After this sale, 100 units remain from the January 5 purchase, and 70 units remain from the January 15 purchase (150 – 80).
For the January 30 sale of 200 units: Start with the most recent purchase: all 120 units from January 25 at $13.00 per unit, totaling $1,560. The remaining 80 units (200 – 120) come from the next most recent batch: the 70 units from January 15 at $12.00 per unit, totaling $840. The remaining 10 units (80 – 70) come from the January 5 purchase at $10.00 per unit, totaling $100.
The total COGS for the January 30 sale is $1,560 + $840 + $100 = $2,500. The total COGS for the period is the sum of both sales: $960 (January 20) + $2,500 (January 30) = $3,460.
To determine ending inventory value, identify remaining units and their costs. After the January 30 sale, 90 units remain from the January 5 purchase (100 – 10), which are the oldest units. Ending inventory is valued at $900 (90 units $10.00/unit). This leaves older, lower costs on the balance sheet as inventory.
Impact on Financial Statements
The choice between FIFO and LIFO affects a company’s financial statements, particularly the income statement and balance sheet. This impact is especially noticeable when inventory costs are changing. The primary difference lies in how each method values the Cost of Goods Sold (COGS) and ending inventory.
In rising prices, FIFO generally results in lower COGS, as older, less expensive goods are sold first. This leads to higher gross profit and net income. Ending inventory under FIFO reflects more recent, higher costs, resulting in a higher balance sheet value. This can make a company appear more profitable and may result in a higher tax liability.
Conversely, in rising prices, LIFO typically results in higher COGS, as the most recently acquired, more expensive goods are sold first. This leads to lower gross profit and net income. Ending inventory under LIFO reflects older, lower costs, resulting in a lower balance sheet value. This higher COGS can lead to lower taxable income and reduced income tax expense.
The Internal Revenue Service (IRS) generally requires LIFO for tax purposes to also be used for financial reporting, known as the LIFO conformity rule. Companies using LIFO are also required under U.S. GAAP to disclose a “LIFO reserve,” indicating the inventory value difference if FIFO had been used.