Comparison of FIFO and LIFO inventory methods

LIFO and FIFO Inventory Valuation Methods

FIFO or LIFO

A Comparison of LIFO and FIFO Inventory Valuation Methods

There are a number of considerations when choosing between the inventory tracking and valuation methods of 'first in, first out' (FIFO) and 'last in, last out' (LIFO). These include the company's balance sheet, income statement, cash flow statement, and tax considerations (Drive Your Success, 2010).

Antibiotics

The FIFO and LIFO methods of inventory tracking can be calculated independent of the actual physical movement of goods into and out of the inventory or be used to track the physical movement of goods (Fried, n.d.). If used independently of the physical movement of goods then the purpose is to analyze the flow of costs during the year. Given that the goods in the Excel spreadsheet example are antibiotics, the physical inventory control method used would likely be FIFO in order to minimize how much of the inventory has to be discarded during the year because of a short shelf life. Discarding inventory increases the cost of goods overall and lowers profit.

The antibiotic example in the Excel spreadsheet reveals the difference in the valuation of the inventory at year end, depending on whether FIFO or LIFO was used. Essentially, the FIFO method removes from inventory those goods that were purchased first and LIFO removes the most recently purchased goods from inventory first. If the cost of goods was under inflationary pressure during the year, which this example suggests, then at year-end the inventory will have a higher value under FIFO than LIFO because the most expensive goods will still be in inventory.

Balance Sheet, Income Statement, Cash Flow Statement, and Tax Implications

When FIFO is used the value of the year-end inventory is higher because the lowest cost goods are sold first. Since the goods sold have a lower cost, gross profit and net income are increased. This will increase tax liability in terms of the company's profit (Fried, n.d.). When LIFO is used the cost of goods sold is higher, which reduces profit and net income and lowers tax liability. It should be noted that the U.S. tax code requires that the same inventory valuation method be used for both tax and financial reporting purposes (Fried, n.d.) and LIFO is banned in the United Kingdom (Drive Your Success, 2010).

The ability of a balance sheet or income statement to accurately reflect cost of goods also differs. When using LIFO the cost of goods is more accurately reflected in the income sheet than on the balance sheet, whereas FIFO produces the opposite effect. This phenomenon is related to the difference in how these two statements evaluate a company, with a balance sheet giving a 'point in time' view and an income statement providing a long-term view.