The difference between FIFO and LIFO
Choosing a method to assess the inventory costs of your business can affect the profits you record. Since the level of profits you record will directly affect the income tax you have to pay, choosing the right method for your business is vitally important.
The inventory of a business is a record of two things:
Items that have been purchased with the intention of reselling them
Items produced by the business – this will include the costs of labour, the manufacturing process, the materials used and overheads
What do FIFO and LIFO stand for?
Before explaining how FIFO and LIFO work for calculating inventory, it’s probably best to simply explain what each actually means:
FIFO stands for First In First Out and refers to the value of inventory calculation. Using this method is based on the value of the oldest products. In most businesses, the oldest products are the first to be sold, since they risk becoming unsellable (i.e. a summer outfit in autumn) and being rendered obsolete.
LIFO stands for Last In First Out and uses the value of the most recently purchased or produced goods as a template via which to calculate the cost of goods sold (COGS)
Whether using FIFO or LIFO a business will be attempting to arrive at an assumption on the total COGS based on a calculation.
Which works best – FIFO or LIFO?
While neither FIFO nor LIFO actually tracks the value of inventory in real time, there is a strong argument for saying that FIFO offers a more trustworthy and accurate means of making an estimate. The reason for this is that it most closely resembles how most businesses handle their inventory in the real world.
LIFO, on the other hand, means that a business can use the costs of their most recent items as the basis of the COGS calculation. That items purchased more recently are generally more expensive than older items means that the COGS calculation is highly likely to be higher using LIFO.
Reducing declared profits in this way may lead to a lower tax bill, but it will also create a balance sheet that is less attractive to people such as investors.
How to make the calculation
Whether FIFO or LIFO is being used, the actual calculation itself is relatively simple:
In both cases the items used for the calculation must have been sold – unsold items of inventory cannot be used to calculate COGS.
Using the example of a shop which sells umbrellas, we can demonstrate how the FIFO and LIFO methods produce different results. During the course of a week the inventory costs for the bike shop have been:
On Monday the shop acquires 100 umbrellas at a cost of £5 each
On Tuesday the shop acquires 100 umbrellas at a cost of £5.50 each
On Wednesday the shop acquires 100 umbrellas at a cost of £6.00 each
On Thursday a sudden downpour drives record sales of 250 umbrellas at £15 each.
Using FIFO to calculate COGS will mean the £5 figure is used, and the COGS is £1,250.
Using LIFO to calculate COGS means the £6 figure will be used, and the COGS is £1,500.
In both cases the money generated through umbrella sales is £3,750. Using FIFO the profit will be estimated at £2,500, whereas using LIFO produces a figure of £2,250.
We can help
A key aspect of inventory management involves keeping highly accurate records of the payments you have coming into your business. Partnering with a payment platform like GoCardless makes this as simple as possible and this includes the more complex aspects such as dealing with ad hoc payments or recurring payments.