FIFO vs LIFO Inventory Valuation for SMBs

Understanding the key differences between FIFO (First-In, First-Out) vs LIFO (Last-In, First-Out) is essential for businesses that want to maintain accurate financial records and optimize operational efficiency. 

Inventory refers to the goods and materials a company holds for resale or production. It is typically categorized into three types: raw materials (the basic components used in manufacturing), work-in-progress (items in the process of being manufactured), and finished goods, which are completed products ready for sale. 

The choice between FIFO and LIFO directly impacts how inventory is valued and reported. This influences businesses’ financial statements and tax obligations.

What Is FIFO?

FIFO (First-In, First-Out) is an inventory valuation method in which the oldest inventory items are recorded and sold first. The FIFO inventory method is especially popular in small and medium-sized businesses (SMBs) that sell perishable goods or other time-sensitive items like pharmaceuticals, seasonal items, or fashion wear.

The cost of goods sold (COGS) is based on the price of the earliest purchased inventory when a sale occurs under the FIFO method. The remaining inventory after the sale will reflect more recent purchase prices.

FIFO is relatively straightforward to implement and is accepted under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Its transparency and logic make it a solid choice for many SMBs seeking a simple and consistent inventory management system. 

FIFO aligns well with physical inventory flow for perishable and time-sensitive goods. It also contributes to more efficient inventory management, as it helps business owners manage expiration risks.

Example

Let's imagine a company in Jacksonville, Florida, that produces breakfast cereals and uses the FIFO inventory valuation method. The cost of raw materials is increasing month-over-month:

• In January, they purchased cereal ingredients at $2.00/lb.

• In February, they purchased more at $2.10/lb.

• In March, their purchase went up to $2.30/lb.

Under FIFO, the oldest inventory costs (from January) are recorded as COGS. This means that any cereals the company sells in April will be based on the January COGS, even though current market prices are higher.

Economic and Tax Consequences of Using FIFO

Recording lower COGS will lead to higher reported profits, at least on paper. However, higher profits also lead to a higher tax burden. 

In the wider context, FIFO will help the company make informed pricing decisions and maintain its competitive advantage as its margins reflect the actual cost flow. Ask an expert in small business accounting if FIFO aligns with your business goals or if you would gain more benefits from implementing LIFO.

What Is LIFO?

LIFO (Last-In, First-Out) is an inventory valuation system in which the most recently acquired inventory is sold first. This means the newest inventory costs are recorded as COGS, and the older costs remain on the balance sheet as inventory.

Some companies choose the LIFO inventory method in times when inflation is hitting profits. This is because the combination of higher COGS and lower profit margins leads to lower taxable income. It's also beneficial for gaining a more realistic picture of profitability, as current costs match current revenues.

Please note: LIFO accounting isn't allowed under IFRS. This makes it unviable for U.S. companies that operate globally.

Example

LIFO is most commonly used in industries with non-perishable goods or variable input costs. Let's take a U.S.-based industrial chemical manufacturer. One of their most important raw materials is a chemical derived from crude oil. This means its price frequently fluctuates as oil prices are highly volatile:

• In January, the chemical cost $50 per gallon.

• In February, the chemical cost $55 per gallon.

• In March, the chemical cost $60 per gallon.

In April, the company sold a product that uses 1,000 gallons of the chemical. The company accounts for the sale under LIFO, at the most recent purchase price ($60 per gallon). This means the COGS for the purchase is $60,000. The lower-priced batches from January and February continue as inventory on the balance sheet.

Economic and Tax Impact

Using a higher COGS reduces the company's gross profit and taxable income. The cash savings can then be reinvested or used to cushion the company against future price rises.

However, leaving older, cheaper inventory on the books may understate its value. This could have a detrimental effect on financial ratios and asset valuation.

FIFO and LIFO vs Standard Costing

FIFO and LIFO are two of the most popular inventory valuation methods, although others also exist. Credit Suisse found in their annual reports from 2021 and 2022 that around 55% of companies in the S&P 500 used FIFO as their main inventory valuation method, while 15% favored LIFO.

Many companies also use standard costing internally. This method assigns a fixed cost to inventory items based on estimated production costs. It helps businesses track variances, monitor efficiency, and control budgets. However, for external financial statements, companies must still adjust to actual costs using methods like FIFO or LIFO to comply with GAAP, or FIFO-only to comply with IFRS.

The Impact of Inflation on FIFO and LIFO

The choice between FIFO and LIFO is particularly important for businesses during times of rising prices. This is because the method used impacts tax liability, profitability, inventory valuation, and cash flow more during inflationary periods.

LIFO arguably provides a more realistic match of current costs and revenues during inflation. This helps to reduce the impact of inflation on the company and its stakeholders. 

Using FIFO during times of inflation results in higher profits on the books, as the lower-priced inventory that was purchased first is sold at current (higher) prices. This results in a higher tax liability at the same time the business faces higher repurchase costs.

Which is best? Switching to LIFO during periods of high inflation results in higher COGS and lower pre-tax income. The resulting tax savings grow as inventory prices rise. Consult an accounting professional to determine whether changing to LIFO could help to mitigate the effects of inflation, reduce your company’s tax burden, and increase cash flow available for reinvestment.

FIFO vs LIFO on Financial Statements

The inventory valuation method you choose directly influences your company's profitability, tax burden, and the value of your assets, as recorded on your company's financial statements.

Income Statement

The income statement reflects revenue, COGS, gross profit, operating income, and net income. Implementing FIFO or LIFO will mainly impact COGS, which has a flow-on effect on profitability and tax liability.

FIFO and the Income Statement

Using older, less expensive inventory first leads to lower COGS. This means gross profit and net income are generally higher. Though this will likely lead to higher income taxes, your company appears more profitable on paper. This is highly appealing for businesses looking to sell or attract investors.

LIFO and the Income Statement

Conversely, using newer, more expensive inventory first leads to higher COGS. This leads to less taxable income as reported profit is also lower. This approach may be favorable for companies that are looking to improve their cash flow.

However, companies using LIFO should be aware of the risks of LIFO liquidation. This occurs when a business sells more inventory than it purchases, and must dip into older inventory that was purchased at much lower prices. 

This has several flow-on effects, including an artificially reduced COGS and misleading gross profit. This will lead to higher taxable income in the short term and could mislead investors or stakeholders, as the increase in net income is temporary and unsustainable.

Balance Sheet

The balance sheet reflects assets, liabilities, and equity. FIFO and LIFO have a large impact on the balance sheet, as inventory is considered a current asset. Its value is instrumental in determining your total asset value and working capital ratios.

FIFO and the Balance Sheet

FIFO offers a more accurate picture of your current inventory, as it reflects the cost of the most recently acquired inventory. Using FIFO will result in a higher total asset value and a stronger-looking balance sheet. However, leaving newer and more expensive inventory on the balance sheet leaves it more exposed to sudden value losses, AKA inventory depreciation.

LIFO and the Balance Sheet

Using LIFO may understate your company's value, as the inventory value reflects older and cheaper purchase prices. It will result in lower asset valuation.

Cash Flow Statement

FIFO often results in higher reported profits on the cash flow statement, while LIFO potentially improves cash flow by reducing income taxes in times of inflation. However, neither of these inventory valuation methods directly impacts the actual cash flow generated from operations. Rather, it affects your tax liability.

Advantages and Disadvantages of FIFO and LIFO

FIFO and LIFO both have pros and cons. While both methods are beneficial for some businesses, neither is the right choice for all businesses.

Pros and Cons of FIFO

Consider the following advantages and disadvantages of using FIFO in your company: 

Advantages:

• Lower COGS leads to higher reported profits during inflationary periods.

• Inventory reflects its current market value on the balance sheet.

• FIFO is simple and intuitive, especially for companies that sell perishable goods.

• FIFO is accepted under GAAP and IFRS.

• FIFO gives companies a clear picture of cost flow for perishable goods.

Disadvantages:

• Higher taxable income leads to a higher tax liability.

• Lower COGS doesn't reliably reflect the true cost of replacing inventory during periods of high inflation.

• FIFO may result in overstated profits. This creates an unrealistic base on which to make sound business decisions.

• FIFO complicates tax planning, especially in industries with rising costs or during times of inflation.

Pros and Cons of LIFO

The following are the main advantages and disadvantages of implementing LIFO:

Advantages: 

• LIFO results in lower taxable income during times of inflation.

• LIFO matches current costs to current revenues more accurately.

• LIFO is potentially favorable for companies looking to make tax savings and improve cash flow.

Disadvantages:

• LIFO potentially understates profits. This makes the company look less successful than it actually is.

• LIFO may distort financial ratios like return on assets.

• LIFO undervalues the ending inventory balance as it reflects older costs.

Inventory valuation methods also impact exposure to value loss. FIFO often results in higher inventory values, which may increase the risk of write-downs if market prices fall. LIFO may reduce this risk, but it leaves outdated inventory on the books that may eventually become unsellable and need to be discounted heavily or written off.

When to Choose FIFO vs LIFO

Many factors influence whether FIFO or LIFO is the best inventory valuation method for your business. The nature of your inventory is the most influential. However, it's also vital to take economic factors into account. The following table summarizes four key factors for consideration and when to choose FIFO or LIFO.

Factor	Choose FIFO	Choose LIFO
Nature of Inventory	Perishable, time-sensitive, or seasonal goods (such as food, cosmetics, pharmaceuticals, or holiday-specific SKUs)	Non-perishable, durable goods (such as chemicals, hardware, and construction materials)
Financial Reporting Goals	To report higher net income and inventory value, and look better to investors and lenders	To lower net income and reduce your tax burden
Tax Strategy	Higher taxable income during inflation	Lower taxable income during inflation
Economic Conditions	Better performance in stable or deflationary environments	More beneficial in inflationary periods

Align Inventory Valuation With Business Goals

Choosing between FIFO and LIFO directly impacts your company's financial health, especially during periods of inflation. Each method offers unique advantages depending on your business type, market conditions, and strategic goals.

Understanding how these inventory valuation methods affect your income statement, balance sheet, and tax obligations empowers you to make informed, long-term financial decisions. Consult with an experienced accounting professional to ensure the method you choose aligns with your operational realities and growth objectives.