FIFO vs LIFO: Which One Is Better for Inventory Valuation?

Posted by
Tetiana Belevska

Updated October 19, 2023

There is more to inventory management than filling in the amount you pay for your products into your accounting system. There are a couple of ways to manage inventory, and choosing the best inventory management method isn’t that simple. So, what would you choose: FIFO vs LIFO? To sell the new product or the old item first?

For sure, both inventory valuation methods differently influence your tax situation, record-keeping process, and inventory flow. But, which method meets your business needs? Let’s find out.

What Is the Last-In-First-Out Method in Accounting?

First things first, what is the LIFO method? The “Last-In-First-Out” (LIFO) process is the inventory valuation method that ensures businesses sell the last-placed products first.

LIFO focuses on the item that you make a sale with. Even if you have old stock still on a shelf. This method is specifically useful when you have perishable products coming in or when stock frequently changes costs. LIFO matches the latest costs of inventory. However, it can be hard for you to calculate profit with the LIFO method. Especially when your stock needs shifting or looks old.

On top of that, LIFO allows a company to first use its most recent inventory costs. Typically, these costs are higher than what they spend to manufacture or purchase older inventory. This way, profits are lower. However, your company pays less tax under LIFO. On the other hand, your stated profits are less accurate than the ones with FIFO; older inventory displays the actual costs you paid for that inventory.

When you want to manage your inventory with the LIFO method, consider some points:

• LIFO isn’t a very natural method
• Inflation might affect old inventory
• The record-keeping process is rather complicated
• You may lose profit due to deflation
• Fluctuation reporting becomes more complex because of inventory layers
• You are restricted in financial reporting *

To calculate COGS (cost of goods sold) with the FIFO method, you need to define the cost of your recent inventory. Then multiply it by the number of sold inventory.

* LIFO is allowed only in the USA as it is under Generally Accepted Accounting Principles (GAAP). However, it isn’t allowed under the International Financial Reporting Standards (IFRS) followed in the EU, Japan, India, Canada, and many other countries.

Who Uses LIFO Method?

Companies that sell products rising in price every year use LIFO as they benefit from it. This main reason is that these companies can better match their revenues to their latest costs. Plus, they can also save on taxes accrued under other forms of cost accounting. They can also handle fewer inventory write-downs.

In reality, any business facing rising costs can benefit from LIFO. For instance, many pharmacies and supermarkets use the LIFO method for inventory management because almost every product they stock experiences inflation. The same applies to convenience stores, especially those that sell tobacco and fuel. They decide to use LIFO because the costs of these products have risen greatly over time.

Based on the American Institute of Certified Public Accountants survey, more than 400 companies out of 600 use LIFO for both financial and tax reporting. For instance, Walmart implements LIFO in their U.S. segment’s inventories.

What Is the First-In-First-Out Method in Accounting?

By its very core, the “First-In, First-Out” (FIFO) method is simpler to understand and carry out. Most businesses discharge older products first as older inventory may lose value or become obsolete. This way, old items aren’t left hanging around.

Whether you’re managing a brick-and-mortar company or an e-Commerce site, the outcome is the same. Basically, whatever you have at the front of the queue sells first. So, you discharge products in the order they arrive at the warehouse.

On top of that, your process and calculate your net income, profit, and stocktake based on this method of selling. This, in fact, influences your inventory accounting and the amount of taxes you pay.

When you follow the FIFO method, you probably use the actual price paid for items and/or raw materials. It also means that you don’t lose money on your stock. As FIFO follows the inventory natural flow, fewer chances of mistakes in bookkeeping are likely to happen. Mainly, it influences the bookkeeping reports when you add everything up at the end of the accounting period.

When you look at the FIFO method for accounting, consider:

• Inflation can affect your tax
• It’s an easy method due flow of goods
• There isn’t as much fluctuation
• You get no restrictions on financial reporting
• The inventory method positively affects record-keeping
• Deflection means you pay less for stock

To calculate the cost of goods sold (COGS) under FIFO, you need to define the costs of your oldest inventory. Then multiply that cost by the number of sold inventory.

Who Uses the FIFO Method?

Over the course of time, businesses using the FIFO method seem to be more profitable - at least based on their reports. Such an assumption arose due to the rise of production cost and the economic fluctuations.

For example, a grocery store acquires milk at specific intervals to have it back in stock. The sellers put the oldest items in the front of the fridge while placing the newer ones behind. This way, they sell the cartons of milk with the nearest expiry dates first. At the same time, the later expiration dates are the last to be sold. In such a way, companies ensure that they sell products before they expire to avoid lost profit.

So FIFO is a suitable method of inventory valuation for companies selling food products, designer fashions, and other perishable items or units subject to obsolescence. This inventory method provides them with an overview of the ending inventory value on the balance sheet. At the same time, FIFO helps them increase net income because they use old inventory to value the cost of goods sold (COGS).

Besides, businesses looking for investors also use the FIFO method until they earn higher income to have a higher tax liability. This inventory valuation method records a higher level of pretax income and results in a lower recorded cost per item. However, companies with higher profits might face higher taxes.

Apple Inc. is one of the most known companies to use FIFO. This way, they ensure that old-model units are sold before they release any new Apple product to the market. Plus, Apple Store managers also deal with inventory in their respective stores.

FIFO vs LIFO: Pros and Cons

When deciding between these two inventory valuation methods, first you face the difference between FIFO and LIFO. The main issue lies in the fact that there is a fluctuation in the price paid for an item and a variation of the stock accounted for.

In reality, LIFO and FIFO are assumptions only. The inventory management methods aren’t linked to the physical inventory tracking, but only inventory totals. However, it means that a business using the LIFO could offload older acquired inventory first, or vice-versa with FIFO. But, the question remains: which inventory method is better?

Let’s look at FIFO vs LIFO advantages and disadvantages.

FIFO Benefits and Drawbacks

FIFO is considered to be the more trusted and transparent method for inventory management. Here are the reasons why:

• More accurate inventory results: Calculating profit from stock is easier. So your financial statements are simple to update. Plus, it means you don’t have old stock left for a long time until it becomes obsolete.
• Lower chances of income manipulation: Under FIFO policy, you have no vagueness about the values to use in profit and loss statements.
• Widely-used approach: FIFO is a widely accepted method of inventory valuation that increases its consistency and comparability.
• Display increased net and gross profit: In the periods of increasing prices of goods, this method still points out an increased gross and net profit. The main reason lies in the fact that the cost of sales includes inventory figures. And, while first inventories always cost less than the recent ones during inflation, the reported income might be higher.

There are some bad points to the FIFO method as well. Among the main disadvantages are:

• Higher amount of tax: On one hand, you earn more profit with FIFO. On the other hand, you pay more taxes.
• Potential clerical errors: You need a higher amount of data to extract the cost of goods. When you balance your beginning and ending inventory, FIFO can mix profit results because of changes in economic periods.

LIFO Advantages and Disadvantages

The LIFO method brings a lot of benefits to small and big companies. Here are some pinpoints to consider when picking LIFO accounting:

• Tax benefits & improvement in cash flow: When you use LIFO in periods of inflation, you match the current purchase at higher prices against the revenue. This way, you reduce the overstatement of profit, as well as the income tax bill.
• Minimize write-downs to market: Companies using LIFO might not have their net income affected by the price decline. Usually, these businesses don’t have a lot of products at current higher prices as they sell them first. So they minimize or even eliminate the chances of write-downs to market because of the decline in inventory prices under LIFO.
• The physical flow of inventory: In some situations, the LIFO cost flow corresponds to the physical flow of inventory.
• Matches most recent costs against current revenues: LIFO provides a better measurement of current income based on a comparison between most recent costs and current revenue. This way, LIFO lets companies reduce the inventory profits, cut overstatement of profit, and understatement of cost of goods sold (COGS).

Only looking at the LIFO benefits doesn’t give you a clear overview of its usefulness to your business. Here are some disadvantages you need to know:

• Manipulation of income: Some businesses might manipulate their income with the LIFO method. Mainly, they change their purchasing behavior at the end of the year.
• Understatement of inventory: Using LIFO results in an understated inventory number in the balance sheet. This happens because the method uses older costs in computing inventory value. Plus, the understated inventory figure also displays worse working capital.
• The problem of LIFO liquidation: The LIFO liquidation might inflate the reported income for a specific period leading to higher tax payments for that period. As a result, companies tend to purchase items in large quantities to match them against their revenue.
• Reduced earnings in inflationary times: When you use LIFO, your report earnings might look low in inflationary times. This can lead to a situation when potential investors might not lend you the amount of money.

What Accounting Systems Offer Inventory?

Having a strong inventory solution is important for any business. It allows you to know what to reorder and when. It also shows you how much stock you have of a specific product and how well it sells. Besides, it keeps your inventory moving and prevents your items from gathering dust in the warehouse. Let’s check the most popular accounting system options for inventory.

Zoho Books

Zoho Books is all-in-one accounting and inventory software that can help you keep track of your items from monitoring stock levels to re-ordering them. Mainly, Zoho Books includes an inventory management feature so you can:/p

• Capture complete product details: You can organize your inventory with all essential information including cost, vendor details, product images, available for sale, stock on hand, and more.
• Do business with customized rates: Use markups and markdowns to create a customized price list and give it to your preferred customers and vendors.
• Never run out of stock: Monitor your products from the most you create them. Tracking inventory lets you keep a close eye on your stock levels anytime.
• Record inventory changes: You can adjust your inventory in time. Whether your stock gets damaged or lost, you can easily keep inventory levels up to date.
• Stay informed with detailed inventory reports: Use reports to use your stock on hand at any time. Plus, view its current valuation at any time. Zoho Books implements the FIFO method.

If you need more advanced inventory management software, you can integrate Zoho Inventory into your Zoho Books account.

QuickBooks Online

QuickBooks makes inventory tracking less time-consuming for small and medium-sized businesses across the globe. The software can help you seamlessly manage your stock to keep you updated all the time. With QuickBooks Online, you can:

• View your quantities on hand: Get auto-updates on your inventory every time stock comes in and out.
• Track stock value in real-time: Whenever the value of your stock changes, your balance sheet does the same. Have your values automatically adjusted during the day.
• Stay on top of orders: You can keep track of ordered items from every supplier. Organize contact information for each supplier in one place so you can reorder it easily.
• Get inventory insights: Run reports to see total taxes, total sales, and best-selling products.
• See real-time inventory values: Automatically adjust your inventory values in your balance sheet.
• Track inventory by date or item: See the quantity on hand for a certain date by customizing reports. Plus, you can track and sort your taxable and non-taxable inventory.

QuickBooks Online lets you track 4 types of items: services, bundles, inventory items, and non-inventory items.

Xero

Xero remains one of the simplest inventory management software up to date. With this platform, you can keep track of what you have in stock, populate orders and invoices with items. The Xero functionality lets you:

• Track items in stock: You can track up to 4000 finished items, look up the quantity. Plus, see the total value of the stock on hand for any product.
• See what is selling: View best and worst-selling items. Discover the most profitable and least profitable lines.
• Add items to invoices: You can create reusable text (prices and descriptions) so that you can use them in purchase orders, invoices, and quotes.
• Adjust the quantity or value of items: You can adjust the average cost, the quantity on hand, or the total value of a specific inventory item.
• Import or export inventory details: Use the CSV template to import details of items. Or export your list of items to a CSV or PDF file.

Odoo

Odoo includes a double-entry inventory system to better organize your stock and improve all your internal operations. The platform’s inventory has no stock transformation, input or output. Instead, you get stock moves between locations. Using Odoo, you can:

• Manage inventory valuation: Odoo supports Standard Price, Average Cost (AVCO), and FIFO for product costing methods.
• Forecast your inventory: Get forecasts of purchase orders, manufacturing orders, internal moves, or product availability based on confirmed sales orders.
• Improve traceability: Tracks manufacturer lots with serial numbers or barcodes. Determine and pick which transactions require (receptions, internal moves, delivery orders, etc.)
• Get advanced routing: Deliver to customers from suppliers based on orders, products, or customers. Design your product routes and manage all your warehouses with the same software.
• Adjust your inventory: Do an inventory for a zone, a lot, a pallet/box, or a specific product; Odoo prepares cycle counts for you.

Does your current accounting platform lack inventory management? Want to move to one of the listed solutions? We can help to make it automatedly and securely – give a test drive to our migration service and run a free Demo.

Should You Choose FIFO vs LIFO?

Choosing the inventory valuation method depends on a number of factors. The amount of tax plays a huge role in your decision, but it shouldn’t be the only thing to consider before picking between FIFO vs LIFO. Think about inflation, fluctuation, and the record-keeping process as well.

Yes, FIFO is the most common inventory management method, but don’t default to using it. In specific cases, LIFO might be the better option. Speak about your inventory management options with accountants. They can help you choose the right one based on your inventory flow, tax situation, product type, and record-keeping requirements.