How to Calculate LIFO and FIFO Inventory Methods
Learn to precisely apply LIFO and FIFO inventory methods. Understand their direct effects on financial reporting and asset valuation.
Inventory is a significant asset for many businesses, and accurately determining its value is a core accounting function. Companies track the cost of goods sold and the value of items remaining at period end. The First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) inventory costing methods are two widely adopted approaches. These methods assign costs to inventory, directly influencing financial statements.
Understanding Inventory Costing Basics
Inventory refers to goods a business holds for sale, items in production, or materials used in production. Accurately valuing this inventory is necessary for financial reporting and calculating profitability. The objective of inventory costing is to allocate the total cost of goods available for sale between two primary financial categories.
Cost of goods available for sale encompasses beginning inventory plus all purchases during a period. This total cost is then divided between cost of goods sold (COGS) and ending inventory. COGS represents the expense of inventory items sold during the period and appears on the income statement. Ending inventory represents the value of unsold inventory remaining at period end and is reported as a current asset on the balance sheet.
Calculating Using FIFO
The First-In, First-Out (FIFO) inventory costing method assumes the first units purchased are the first ones sold. This approach aligns with the natural flow of many businesses, especially those dealing with perishable goods or products with limited shelf lives. Under FIFO, costs assigned to goods sold are from earliest purchases, while costs assigned to remaining inventory reflect most recent purchases.
To calculate Cost of Goods Sold (COGS) using FIFO, identify the number of units sold and assign costs starting from the oldest inventory. For example, if 200 units are sold, the first 100 units are costed from the earliest inventory (e.g., $10 each). The remaining 100 units come from the next oldest batch.
A business has inventory purchases: 100 units at $10 (Jan 10), 150 units at $12 (Feb 15), and 80 units at $15 (Mar 20). If 200 units sell on April 5, FIFO COGS begins with earliest units. The first 100 units sold are costed at $10 each ($1,000). The remaining 100 units come from the February 15 purchase of 150 units at $12 each ($1,200).
Total FIFO Cost of Goods Sold for the 200 units is $1,000 plus $1,200, equaling $2,200. To determine ending inventory under FIFO, remaining units are identified and costed based on most recent purchases.
After selling 100 units from the February 15 purchase, 50 units remain from that batch at $12 each ($600). All 80 units purchased on March 20 at $15 each also remain ($1,200). The FIFO ending inventory is $600 plus $1,200, totaling $1,800. This method ensures inventory on the balance sheet reflects costs closest to current market prices, as it assumes latest purchases are still on hand.
Calculating Using LIFO
The Last-In, First-Out (LIFO) inventory costing method assumes the most recently purchased units are the first ones sold. This accounting convention does not necessarily reflect the physical flow of goods for most businesses but is an acceptable method for financial reporting in specific circumstances. Under LIFO, costs assigned to goods sold are from latest purchases, while costs assigned to remaining inventory reflect earliest purchases.
To calculate Cost of Goods Sold (COGS) using LIFO, identify the number of units sold and assign costs starting from the most recent inventory. For example, if 200 units are sold, the first 80 units are costed from the latest inventory (e.g., $15 each). The remaining 120 units come from the next most recent batch.
Using the same scenario, if the business sells 200 units, the LIFO calculation for COGS begins with the most recent units. The first 80 units sold are costed at $15 each ($1,200). The remaining 120 units come from the February 15 purchase of 150 units at $12 each ($1,440).
Total LIFO Cost of Goods Sold for the 200 units is $1,200 plus $1,440, equaling $2,640. To determine ending inventory under LIFO, remaining units are identified and costed based on oldest purchases.
After selling 120 units from the February 15 purchase, 30 units remain from that batch at $12 each ($360). All 100 units purchased on January 10 at $10 each also remain ($1,000). The LIFO ending inventory is $360 plus $1,000, totaling $1,360. This method tends to result in lower inventory values on the balance sheet during periods of rising prices, as oldest, lower costs are assigned to remaining inventory.
Impact on Financial Reporting
The choice between FIFO and LIFO significantly affects a company’s financial statements, particularly the income statement and balance sheet. Using the previous example, FIFO yielded COGS of $2,200 and ending inventory of $1,800. LIFO resulted in COGS of $2,640 and ending inventory of $1,360 for the same purchases and sales. These differences directly influence reported profitability and asset values.
On the income statement, a higher COGS (LIFO: $2,640 vs. FIFO: $2,200) in a period of rising prices leads to lower gross profit. Gross profit is calculated as net sales minus COGS. A lower gross profit typically results in lower net income, impacting reported earnings. This can also lead to lower income tax obligations due to reduced taxable income, often why some companies prefer LIFO when permitted.
On the balance sheet, ending inventory value is reported as a current asset. In the example, FIFO reported ending inventory at $1,800, while LIFO reported it at $1,360. A higher ending inventory value under FIFO suggests a stronger current asset position compared to LIFO, influencing financial ratios like the current ratio. These reported figures provide different perspectives on a company’s financial health and operational efficiency.