LIFO vs. FIFO

FIFO vs. LIFO

FIFO vs. LIFO

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Inventory represents the value of goods a company is holding that are available for sale. Inventory is calculated according to the following formula: ending inventory = beginning inventory + net purchases -- cost of goods sold. Corporate managers and investors pay close attention to the value of a company's inventory to determine how quickly the company sells the goods it produces. A growing inventory balance suggests that the company is not producing goods people want, so investors figure that it is not a good investment to keep pumping money into the business if they are not selling off inventory. Carrying such a large inventory balance reduces the company's cash flow because there is a lot of money tied up in inventory that is seating in the warehouse. There are a number of ways to calculate inventory, the most popular being last-in-first-out (LIFO) method and the first-in-first-out (FIFO) method. Under LIFO, the newest units in inventory are assumed to be sold first; the cost of goods sold is based on the most recent inventory costs. Under FIFO, the oldest units are assumed to be sold first; the cost of goods sold is based on older inventory costs.

You might be wondering what FIFO stands for, FIFO stands for first-in, first-out. This means that the first items that come into the warehouse will be shipped out after the oldest items are shipped. Even though you have to pay higher taxes FIFO is still a good way to represent the physical flow of a items in and out through a distribution center. This is one of the most common accounting methods used to keep track of shipped items. Companies usually ship the oldest inventory first to prevent the items from being pushed aside or forgotten about. This method keeps the oldest inventory ready to be shipped whenever it is needed. When inflation is high FIFO is sometimes called "Inventory profits". Inventory profits come from holding onto inventory and increasing physical assets. This isn't the best way to calculate costs and revenues. When inflation occur smaller businesses use FIFO because it makes their financial statements look better and makes it look like there is more inventory on hand. So as the older inventory is sold the newest inventory remains on the book there financial records look better because they still have the more expensive items on record. Businesses can uses this as a way to show more revenue, this is very appealing to potential investors, stock holders Ect. The main disadvantage to using FIFO instead of LIFO is that at the end of the year, the company will have to pay more taxes due to the profits' recorded on their statements. This is why after a company experiences some growth, they switch to LIFO.

When a company uses LIFO instead of FIFO their financial statements usually show a lower liquidity, that is, a lower current ratio, lower equity position, that is, a higher debt-to-worth ratio, Better matching of current costs with current revenues, and conservative profits, because LIFO buffers the effects of inflation. LIFO is another popular used accounting method LIFO stands for last-in, first-out. This means that companies buy new inventory and that inventory is the first items to be ship from the warehouse and the older inventory is left over. When inflation occurs LIFO records the most expensive items sold because they were sold first. So companies get a tax break because the older inventory isn't worth as much. LIFO is not the best way to track the physical flow of items. As you know the company is using LIFO so you shipping items out almost as fast as you are getting them in. LIFO has been a great accounting method since the early 1970's. During that decade, the U.S. experienced its first major rise in inflation in modern times which has continued steadily for almost forty years now. A big drawback to LIFO is that most companies experience a rise in inventory costs. But LIFO is the best way to match current costs with current revenues. Also there financial reports show a lower profit which is less attractive to investors, stock holders, ect. One on the major down falls is that old inventory gets forgotten about, which in turn could cost them money because they might have to sell it at a lower price than what they purchased it for. There are a couple major differences between the two accounting methods. One being that FIFO is a more accurate and more realistic view of the value of your current inventory. And LIFO is not an accurate measure of inventory because you have older inventory still seating around, you' wasting space holding on to it and when you do sell it isn't worth as much as when you originally bought the item.

LIFO vs. FIFO

By: Tom Peggs

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