LIFO and FIFO Inventory Accounting Methods

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LIFO, last-in-first-out and FIFO, first-in-first-out the two most common inventory accounting methods. The choice of the method of inventory accounting by a small business can directly impact its balance sheet , income statement and statement of cash flows. Not only do companies have to track the number of items sold, but they have to track the cost of items each item. These two methods are ways in which they can do that. Each will have a different effect on their financial statements.

How is Inventory Determined?

Inventory can be broken down into three categories: raw materials, work-in-process, and finished goods. Raw materials are inventory used to produce assets for sale. Work-in-process is assets in production for sale. Finished goods are assets intended for sale. The inventory equation is the following:

Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory

There are two common methods for accounting for this inventory.

LIFO - Last-In, First-Out

LIFO assumes that the last items put on the shelf are the first items sold. LIFO is a good system to use when your products are not perishable or become obsolete. Under LIFO, when prices rise, the higher priced items are sold first and the lower priced products are left in inventory. This increases a company's cost of goods sold and lowers their tax liability and, as a result, their net income.

This inventory accounting method seldom approximates replacement costs for inventory, which is one of its drawbacks. In addition, it usually does not correspond to the actual physical flow of goods.

Let's use the gasoline industry as an example. Let's say that a tanker truck delivers 2,000 gallons of gasoline to Henry's Service Station on Monday and the price at that time is $2.35/gallon. On Tuesday, the price of gasoline has gone up and the tanker truck delivers 2,000 more gallons at a price of $2.50/gallon. Under LIFO, the gasoline station would assign the $2.50 gallon gasoline to Cost of Goods Sold and the remaining $2.35 gallons of gasoline would be used to calculate the value of ending inventory at the end of the accounting period.

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FIFO - First-In, First-Out

FIFO assumes that the first items put on the shelf are the first items sold, so your oldest goods are sold first. This system is generally used by companies whose inventory is perishable or subject to quick obsolescence. If prices go up, FIFO will give you a lower cost of goods sold because you are using your older, cheaper goods first. Your bottom line will look better to your investors, if you have any, but your tax liability will be higher because you have higher profit. A positive about the FIFO method is that it represents recent purchases and, as such, more accurately reflects replacement costs.

Going back to the gasoline industry example, under FIFO, the gasoline station would assign the $2.35 gallon gasoline to Cost of Goods Sold and the remaining $2.50 gallons of gasoline would be used to calculate the value of ending inventory at the end of the accounting period.

Financial Statement Problems with LIFO

A LIFO liquidation can result when your company experiences declines in your inventory quantities. In this case, a lot of your older inventory is sold or liquidated. This creates an inflated profit margin that isn't real and seriously distorts net income. This has across the board impacts. You should add the LIFO liquidation profits to the current ratio numerator and adjust the denominator to reflect FIFO inventory instead of LIFO inventory in order to properly state your liquidity position. You should make exactly the same adjustments to the inventory turnover ratio.

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Calculating Cost of Goods Sold

Knowing the cost of the goods you sell allows you to take a larger tax deduction, so it is important to keep track of all costs related to your inventory of products. Calculating Cost of good sold for products you manufacture or sell can be complicated, depending on the number of products and the complexity of the manufacturing process. This "how to" takes you through the calculation for one product, so you can see how it is done and what information you will need to provide your CPA. You will need a CPA or tax professional to calculate COGS for your business income tax return

Time Required: Time Depends on the Variety of Products and Whether You Re-sell or Manufacture

Here's How:

First, here are the basic components of the cost of good s sold (cogs) calculation:
Beginning Inventory Cost
+ Cost of Additional Inventory Manufactured or Purchased during the year
= Cost of Ending Inventory
= Cost of Goods Sold

For example:
$14,000 cost of inventory at beginning of year
+ $8,000 cost of additional inventory purchased during year
- $10,000 ending inventory
= $8,000 cost of goods sold.
The COGS calculation process allows you to deduct all the costs of the products you sell, whether you manufacture them or buy and re-sell them.

There are two types of costs included in COGS: Direct and Indirect.
Direct Costs are costs related to production or purchase of the product.
Indirect Costs are costs related to warehousing, facilities, equipment, and labor.
Determine Direct Costs, including
Cost to purchase the merchandise for resale
Cost of raw materials
Packaging costs
Work in process
Cost of inventory of finished products
Supplies for production
Direct overdead costs related to production (for example, utilities and rent for manufacturing facility)
Determine Indirect Costs, including
Manufacturing materials and supplies
Labor (for workers who actually touch the product)
Costs to store/wholesale the products
depreciation of equipment used to produce, package, or store the product
Salaries of administrators, managers overseeing production
Equipment used for administrative work (not production)
Determine Facilities Costs
Facilities costs are the most difficult to determine. This is where a good CPA comes in. Your CPA must allocate a percentage of your facility costs (rent or mortgage interest, utilities, and other costs) to each product, for the accounting period in question (usually a year, for tax purposes).

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Determine Indirect Costs, including
Manufacturing materials and supplies
Labor (for workers who actually touch the product)
Costs to store/wholesale the products
depreciation of equipment used to produce, package, or store the product
Salaries of administrators, managers overseeing production
Equipment used for administrative work (not production)

Determine Facilities Costs
Facilities costs are the most difficult to determine. This is where a good CPA comes in. Your CPA must allocate a percentage of your facility costs (rent or mortgage interest, utilities, and other costs) to each product, for the accounting period in question (usually a year, for tax purposes).

Determine Beginning Inventory
Inventory includes merchandise in stock, raw materials, work in progress, finished products, and supplies that are part of the items.

Your beginning inventory this year must be exactly the same as your ending inventory last year. If it does not, you will need to submit an explanation for the difference.
Add Purchases
Most businesses add inventory during the year. You must keep track of the cost of each shipment or the total manufacturing cost of each product you add to inventory. For purchased products, keep the invoices and any other paperwork. For items you make, you will need the help of your CPA to determine the cost to add to inventory.
Determine Ending Inventory
Ending inventory costs are usually determined by taking a physical inventory of products, or by estimating.

Ending inventory costs can be reduced for damaged, worthless, or obsolete inventory. For damaged inventory, report the estimated value. For worthless inventory, you must provide evidence that it was destroyed. For obsolete inventory, you must also show evidence of the decrease in value. Consider donating obsolete inventory to a charity.
LIFO or FIFO
The final item to be determined is how which inventory has been sold. There are two acceptable methods for determining which inventory is left at the end of the accounting period: lifo last in first out or fifo first in first out . Your CPA will help you determine which method is best for your business tax situation. If you change your valuation method, you must apply to the IRS for approval. For example, if this is the first year your business is using the LIFO method, you must apply to the IRS to make this change.