What Is the Difference Between LIFO and FIFO?

Inventory is a key asset for businesses. To accurately report financial performance, companies must assign costs to the inventory they sell and hold. Inventory costing methods are systematic approaches for this. First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) are two widely used methods. This article explains them and their differing financial impacts.

Understanding the First-In, First-Out Method

The First-In, First-Out (FIFO) method assumes that the first inventory items purchased are the first ones sold. This means the costs of the oldest inventory are recognized as Cost of Goods Sold (COGS) first. FIFO often aligns with the natural physical flow for many businesses, such as those with perishable goods, ensuring older stock is moved out first.

To illustrate, consider these inventory purchases:
January 1: 100 units at $10 each
January 15: 150 units at $12 each
January 25: 200 units at $13 each

If 300 units are sold, FIFO calculates COGS by expensing the first units purchased. This includes 100 units from January 1 ($10 each) and 200 units from January 15 ($12 each). The total COGS is (100 $10) + (200 $12) = $1,000 + $2,400 = $3,400. The remaining 50 units from January 15 ($12 each) and all 200 units from January 25 ($13 each) form the ending inventory, valued at (50 $12) + (200 $13) = $600 + $2,600 = $3,200.

FIFO expenses the oldest costs first, so the most recent costs remain in the ending inventory balance on the balance sheet. This approach is widely accepted and often preferred for its clear reflection of current inventory values.

Understanding the Last-In, First-Out Method

The Last-In, First-Out (LIFO) method assumes that the most recently purchased inventory items are the first ones sold. This means the costs of the newest inventory are recognized as Cost of Goods Sold (COGS) first. LIFO is a cost flow assumption that does not necessarily reflect the actual physical movement of goods, as newer items might not always be sold before older ones.

Using the same inventory purchases:
January 1: 100 units at $10 each
January 15: 150 units at $12 each
January 25: 200 units at $13 each

If 300 units are sold, LIFO calculates COGS by expensing the last units purchased first. This includes 200 units from January 25 ($13 each) and 100 units from January 15 ($12 each). The total COGS is (200 $13) + (100 $12) = $2,600 + $1,200 = $3,800. The remaining 50 units from January 15 ($12 each) and all 100 units from January 1 ($10 each) make up the ending inventory, valued at (50 $12) + (100 $10) = $600 + $1,000 = $1,600.

LIFO expenses the newest costs first, leaving the oldest costs in the ending inventory balance. LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but is generally not allowed under International Financial Reporting Standards (IFRS).

Comparing the Financial Impact

The choice between LIFO and FIFO significantly impacts a company’s financial statements, affecting profitability, inventory valuation, and tax obligations. These effects are particularly pronounced during periods of changing inventory costs, such as inflationary or deflationary economic conditions.

During periods of rising inventory costs (inflation), LIFO generally results in a higher COGS because it expenses the most recent, more expensive inventory first. A higher COGS leads to lower gross profit and net income. Conversely, FIFO results in a lower COGS during inflation, as it expenses older, less expensive inventory first, leading to higher gross profit and net income.

The impact on ending inventory value also differs. With rising costs, FIFO typically leaves the most recent, higher-cost inventory on the balance sheet, resulting in a higher ending inventory value that reflects current market prices. LIFO, in contrast, leaves older, lower-cost inventory on the balance sheet, which can result in an ending inventory value that is understated compared to current replacement costs.

During periods of falling inventory costs (deflation), these effects reverse. LIFO results in a lower COGS, leading to higher gross profit and net income, as it expenses the most recent, cheaper inventory first. FIFO yields a higher COGS and lower gross profit and net income, as it expenses older, more expensive inventory first. The ending inventory under LIFO would then be higher than under FIFO.

The differing net income figures directly influence a company’s tax liability. In an inflationary environment, the lower net income reported under LIFO can lead to lower taxable income and reduced tax expense, allowing businesses to retain more cash for reinvestment or other purposes. The higher net income under FIFO results in a higher tax obligation in such an environment.

Why Companies Choose Different Methods

Companies choose inventory costing methods based on strategic considerations like tax implications, financial reporting objectives, and industry practices.

A primary reason for choosing LIFO, especially in the United States, is potential tax advantages during periods of rising inventory costs. By reporting a higher Cost of Goods Sold (COGS) and lower taxable income, companies using LIFO can reduce their tax payments, allowing them to retain more cash for reinvestment or other purposes.

The IRS enforces the LIFO conformity rule, which dictates that if a company uses LIFO for income tax purposes, it must also use LIFO for financial reporting to shareholders and creditors. This rule prevents companies from presenting a higher income to investors while simultaneously reporting a lower income to the IRS for tax reduction.

Some argue that LIFO provides a better matching of current expenses against current sales because it assumes the most recent costs are expensed first. This can be appealing for income statement analysis, as it reflects more current economic conditions in the gross profit.

Conversely, FIFO is often preferred for financial reporting because its ending inventory value on the balance sheet more closely reflects current market prices, providing a more accurate representation of the company’s assets. Many businesses find FIFO’s assumption of inventory flow aligns with their physical operations.

Globally, accounting standards play a significant role. While U.S. GAAP permits LIFO, IFRS, followed by most other countries, generally prohibits it. IFRS disallows LIFO because it can lead to outdated inventory valuation and distort profitability, particularly during periods of inflation or fluctuating inventory levels.