When reading any annual report containing financial statements, you see a line item under the current assets section of the balance sheet called inventory, which is mostly self-explanatory—it’s the sum value of all the raw materials and finished goods a company currently has in its inventory. What is not always obvious is the valuation method the company has used to derive the value of its inventory, which can vary from company to company and can have a material impact on the financial statements.
There are many inventory valuation methods. Two of the most common are FIFO and LIFO. When comparing financial statements ormaking investment decisions, it’s crucial to know the difference between these two common inventory valuation methods as the performance indicators of a company that uses one are not directly comparable to those of a company that uses the other.
FIFO vs LIFO – Definitions
FIFO stands for first in, first out. It’s an inventory accounting method that assumes that the first goods produced or manufactured are also the first ones to be sold. Whereas in LIFO accounting which stands for last in, first out, the most recent items that enter the inventory are the first ones that are sold.
These methods are two different responses to the phenomenon of inflation. Companies create financial statements at specific intervals during which they purchase inventory multiple times. The price of the items purchased tends to increase as time goes on therefore the cost of goods sold is not constant throughout each interval. With the LIFO interpretation, the goods that are sold first, have higher costs, leading to a higher COGS amount on the income statement. With the FIFO interpretation, the goods with lower costs are sold first which translates to a lower COGS amount.
In 166 countries where IFRS standards are required, companies are mandated to use FIFO only but the companies in the United States operate under GAAP standards—which were developed by Financial Standards Accounting Board (FSAB) and the Governmental Accounting Standards Board (GASB)—and are allowed to choose between the two.
Maximizing COGS vs Minimizing Taxes
The key term here is interpretation, as these methods are used for reports and the inventory amount is an estimate, not an exact value. It’s an estimate that is calculated by a variety of methods, each resulting in a different number. So, LIFO and FIFO do not reflect what has actually happened in a company’s bank account, rather, it’s just how they are reporting it.
To set an example, imagine you own a company that manufactures disposable coffee cups. For the sake of simplicity, you purchase plastic two times a year, once during the beginning months and once during the last months. During the first half of the year, you produce 1000 cups spending 1 dollar per cup. In the second half, you produce another 1000 cups, but the price of plastic has gone up so each cup costs you 2 dollars to make. At year-end, you create your financial statements and you find that you have brought in 4000 dollars in sales for selling 1000 cups at 4 dollars per cup.
Here is where the valuation method comes into play because you had 2000 cups in inventory and you sold 1000, but which ones? Did you sell 1000 at $1.00 per cup or $2.00 per cup? Using the LIFO method, you have sold the cups for $2 for a profit of 2 dollars and you have an inventory worth 1000 dollars. Using FIFO, you have sold them for $1 for a profit of 3 dollars and your inventory is worth 2000 dollars. Under LIFO, your reported profit is lower which decreases your taxes compared to FIFO.
If there was no inflation, the order of items sold wouldn’t matter but since realistically the prices tend to go up, using one method over the other affects your income statements and taxes.
The Gross Profit Margin
If a company has always sold its most recent purchases for an extended period of time, the inventory number on their balance sheet may no longer reflect the real value of what they have in stock because the old purchases can in theory remain on the balance sheet for years. Therefore, under FIFO, the estimated inventory value is more accurate as the company’s inventory always contains the most recent purchases.
On the other hand, the income statement is more accurate under LIFO. The inventory is not something that most investors care about as it’s the gross profit margin that indicates the performance and efficiency of a business. The gross profit margin is the ratio of gross profit to the net total sales and the higher the number is, the more successful a business is in generating profit. In the example above, although the FIFO method reports more profit, that 75% gross margin ratio is based on the prices from the older purchase and it doesn’t reflect what is currently going on in the market with the most current prices.
