How to Calculate LIFO and FIFO Inventory Costs
Accurately determine inventory value and cost of goods sold. Explore LIFO and FIFO methods and their distinct effects on financial reporting.
Inventory costing is an accounting process businesses use to assign monetary value to goods. This valuation directly impacts a company’s financial statements by determining the Cost of Goods Sold (COGS) and the value of remaining inventory. The First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) methods are two primary techniques for valuing inventory. These methods reflect different assumptions about the flow of costs through a business.
Understanding Inventory Valuation Principles
Inventory valuation is crucial for any business that sells physical products, as inventory often represents a significant portion of a company’s assets. Proper valuation ensures accurate financial statements, which helps in making informed business decisions.
The process directly influences COGS, a key expense on a company’s income statement. COGS represents the direct costs associated with producing or acquiring goods a company sells, including materials and labor. It does not include indirect expenses.
The valuation method chosen dictates how inventory costs flow through a business’s financial records. This involves making assumptions about which goods are sold and which remain in inventory for financial reporting and tax purposes.
FIFO assumes the first goods purchased are the first ones sold, meaning the costs of the oldest inventory items are expensed first as COGS. LIFO assumes the last goods purchased are the first ones sold, meaning the most recent inventory costs are expensed as COGS. These are cost flow assumptions, not necessarily reflecting the physical movement of goods.
Another common approach, the weighted-average method, calculates an average cost for all inventory items. This method divides the total cost of goods available for sale by the total number of units available, resulting in an average cost per unit used to value both COGS and ending inventory. While weighted-average provides a smoothed cost, FIFO and LIFO offer distinct ways to track specific cost flows, each with unique implications for financial reporting.
Calculating Inventory Costs Using FIFO
The First-In, First-Out (FIFO) method assumes that inventory acquired earliest is the first to be sold. This approach aligns with the natural physical flow for many businesses, especially those dealing with perishable goods or products with expiration dates. Under FIFO, the costs of the oldest inventory items are assigned to COGS, while remaining inventory is valued at the cost of the most recently purchased items.
To calculate COGS using FIFO, identify the cost of the oldest units in inventory that were sold. If units sold exceed the quantity of the oldest inventory, move to the next oldest batch to account for remaining units. For ending inventory, the value is determined by the cost of the newest units remaining in stock.
Example Inventory Activity:
Beginning Inventory (January 1): 100 units at $10 each
Purchase 1 (January 10): 150 units at $12 each
Purchase 2 (January 20): 200 units at $13 each
Sales during January: 300 units
To calculate COGS for the 300 units sold: The 100 units from beginning inventory were sold (100 units $10/unit = $1,000). The remaining 200 units sold are taken from Purchase 1 (150 units $12/unit = $1,800). The final 50 units sold (300 total units sold – 100 from beginning – 150 from Purchase 1) are taken from Purchase 2 (50 units $13/unit = $650). Total COGS for January is $1,000 + $1,800 + $650 = $3,450.
To determine Ending Inventory: Total units available for sale were 450 (100 beginning + 150 Purchase 1 + 200 Purchase 2). Since 300 units were sold, 150 units remain (450 – 300). Under FIFO, these remaining 150 units are from the most recent purchases. Therefore, 150 units are from Purchase 2 at $13 each, resulting in an Ending Inventory of $1,950 (150 units $13/unit).
Calculating Inventory Costs Using LIFO
The Last-In, First-Out (LIFO) method assumes that the most recently acquired inventory items are the first ones sold. This means the costs associated with the newest purchases are expensed as COGS. Under LIFO, the value of remaining inventory is based on the costs of the oldest items still in stock. LIFO is accepted under U.S. GAAP but prohibited by IFRS.
When calculating COGS using LIFO, begin by taking the cost of the most recent inventory units sold. If the quantity sold exceeds the most recent purchase, move to the next most recent purchase to account for the remaining units sold. For determining ending inventory value, the remaining units are assigned the costs of the earliest inventory purchases that have not yet been expensed.
Example Inventory Activity:
Beginning Inventory (January 1): 100 units at $10 each
Purchase 1 (January 10): 150 units at $12 each
Purchase 2 (January 20): 200 units at $13 each
Sales during January: 300 units
To calculate COGS for the 300 units sold: The 200 units from Purchase 2 were sold (200 units $13/unit = $2,600). The remaining 100 units sold (300 total units sold – 200 from Purchase 2) are taken from Purchase 1 (100 units $12/unit = $1,200). Total COGS for January is $2,600 + $1,200 = $3,800.
To determine Ending Inventory: Total units available for sale were 450 (100 beginning + 150 Purchase 1 + 200 Purchase 2). Since 300 units were sold, 150 units remain (450 – 300). Under LIFO, these remaining 150 units are from the oldest purchases. Therefore, 100 units are from the beginning inventory at $10 each, and the remaining 50 units are from Purchase 1 at $12 each, resulting in an Ending Inventory of $1,600 ($1,000 + $600).
Comparative Financial Statement Impact
The choice between FIFO and LIFO significantly impacts a company’s financial statements, particularly COGS, ending inventory value, and gross profit. These effects are most pronounced during periods of fluctuating inventory costs, such as inflation or deflation.
During periods of rising costs, common in inflationary environments, FIFO results in a lower COGS. This occurs because FIFO expenses the older, cheaper, inventory costs first. Consequently, a lower COGS leads to a higher reported gross profit and net income. The ending inventory balance under FIFO will reflect the more recent, higher costs, resulting in a higher inventory value on the balance sheet.
Conversely, in an environment of rising costs, LIFO results in a higher COGS. This is because LIFO expenses the newest, more expensive, inventory costs first. A higher COGS leads to a lower reported gross profit and lower net income. For ending inventory, LIFO leaves the older, cheaper costs on the balance sheet, resulting in a lower inventory value. The impact on financial statements reverses in periods of falling prices, where FIFO would yield a higher COGS and lower ending inventory, and LIFO would result in a lower COGS and higher ending inventory.