LIFO and FIFO Examples: How These Inventory Methods Work
Explore how LIFO and FIFO inventory methods impact financial reporting and decision-making with practical examples.
Inventory valuation methods like LIFO (Last In, First Out) and FIFO (First In, First Out) significantly influence how businesses report financial health. These techniques affect cost of goods sold (COGS) and ending inventory values, directly impacting profitability and tax obligations.
Single Purchase Batch Example for LIFO
Consider a scenario where a company purchases 100 units of a product at $10 each. Under LIFO, when 60 units are sold, the COGS is $600 (60 units x $10 per unit). This method assumes that the newest inventory is sold first, which can be advantageous during inflation, as it increases COGS and reduces taxable income. However, the ending inventory reflects older costs, which may not align with current market conditions.
Single Purchase Batch Example for FIFO
In a similar scenario, a company purchases 100 units at $10 each. Under FIFO, when 60 units are sold, the COGS remains $600 (60 units x $10 per unit). This method assumes the oldest inventory is sold first, which can result in lower COGS and higher taxable income in stable or declining price environments. The ending inventory, however, reflects more recent costs, providing a clearer picture of current market value.
Multiple Purchase Scenario
In real-world operations, companies often make multiple inventory purchases over time, requiring more complex calculations under LIFO and FIFO.
Beginning Inventory Setup
Assume a company starts with an initial inventory of 50 units, each valued at $8. This serves as the baseline for inventory calculations. Accurate setup is essential for compliance with accounting standards and reliable financial reporting. The beginning inventory value directly influences COGS and ending inventory, impacting financial statements.
Purchase Entries
As the company acquires additional inventory, each transaction must be recorded in detail. For example, the business purchases 100 units at $9 each, followed by another 100 units at $10 each. These records form the basis for calculating COGS and ending inventory under both methods. Proper documentation ensures compliance with accounting standards and supports accurate financial analysis.
Final Inventory Calculation
The ending inventory and COGS are determined based on the chosen method. Under FIFO, the ending inventory includes the most recent purchases—90 units at $10 each, totaling $900. In contrast, under LIFO, the ending inventory reflects the oldest costs—50 units at $8 and 40 units at $9, totaling $720. These calculations impact net income and tax obligations. Using LIFO for tax purposes, as permitted by the Internal Revenue Code Section 472, can reduce taxable income in inflationary periods. Accurate calculations are critical for transparency and compliance.