Details of the FIFO LIFO Inventory Valuation Methods

March 27, 2011 | Comments (12)

Written by

Jae Jun

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Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

Inventory Valuation Methods in Accounting  – FIFO LIFO inventory Method

Inventory can make up a large amount of the assets on the balance sheet and so knowing how to analyze the inventory, and the method used by management is crucial.

A large part of stock valuation comes from being able to understand how inventory is valued and built.

To put it in the most basic form, inventory is what you have in stock. If you expand on this definition to look at what is involved on the other side of the scale to get the ending inventory amount, the equation for inventory is

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

In words, your beginning inventory along with your purchases and then subtracting what you have sold, results in ending inventory.

But this is where it gets tricky with GAAP rules. Depending on the inventory valuation  method used by the company, the COGS can vary considerably which ultimately affects the ending inventory.

Sadly, it is not as easy as counting what is left on the shelf at the end of the day to get the ending inventory value.

Three inventory valuation methods are used in the US.

1. Average cost method

2. First In First Out (FIFO) method

3. Last in First Out (LIFO) method

Average Cost Method

To put it real bluntly, the average cost method is rarely used. This method does not offer any real convenience or added accuracy.

The equation for average cost method is as follows.

Average Cost = (Total Quantity of Inventory Units) / (Total Quantity of Units)

where

Cost of Goods Sold = (Average Unit Cost) x (Number of Units Sold)

For example if 1,000 toys are produced on Monday at a cost of $1 and then on Tuesday another 1,000 toys are manufactured at a price of $1.05, the average cost method would value the inventory at $1.025 a piece.

FIFO Method

As mentioned previously on aggressive and conservative accounting policies, the FIFO method of valuing inventory is considered to be the aggressive method.

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FIFO works like how you maintain your fridge at home. After you have bought some groceries, you tend to place what you just bought at the back of the fridge in order to finish off the older food before it spoils.

In other words, under FIFO, the oldest goods are sold first and the newest goods are sold last.

As a formula it would look like this

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example above, if 1,000 toys were then sold on Wednesday, the COGS would be $1 per unit. The remaining inventory on the balance sheet would then be worth $1.05 each.

LIFO Method

LIFO is the opposite of FIFO. Instead of the oldest inventory being considered as sold first, the newest product is sold first. While the factory analogy works for the FIFO, consider a bakery. By lunch or evening, the bread baked from the morning will not sell as well as the fresh ones from the afternoon batch.

This means that cost of the latest inventory now becomes the COGS with the cost of the oldest inventory being assigned to the inventory value on the balance sheet.

The equation is essentially the same as FIFO since both are calculated based on batches of unit sold.

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example, the 1,000 units sold on Wednesday would have a COGS of $1.05 per unit, with the remaining 1,000 toys being valued at $1 each.

How Inventory Valuation Affects Profits and Assets

As you can see from above, despite ending with the same 1,000 toys, FIFO assigns the inventory value to be $1,050 compared to the LIFO $1,000.

But another point is that the method of inventory valuation does not just affect the balance sheet. Gross profit also varies considerably. How?

Gross Profit = Sales – COGS

COGS differ under FIFO and LIFO, and if your COGS is low, then that means gross profit will increase.

The table below sums up how each of the three inventory valuations vary.

FIFO LIFO inventory Valuation Method

fifo lifo inventory

FIFO LIFO inventory valuation method

Things to Think About Regarding Inventory

Assuming that the world is in a vacuum, the table above illustrates that FIFO results in the biggest gross profit as well as the highest ending inventory value. This is a reason why FIFO is the method of choice for most companies.

Should a company change its accounting policies to switch from LIFO to FIFO, watch out, as management is more focused on trying to increase earnings instead of improving their operations.

If the toy manufacturer above was using the LIFO method and reported $350 in gross profit but then decided to change to FIFO resulting in a restated $500 gross profit, the accounting change alone has increased gross profit by 42.8%!

Also consider this. FIFO increases net income which would in turn increase taxes, but as I stated previously, most public companies are more concerned with showing an increase in earnings.

On the other hand, LIFO is not a good indicator of ending inventory as the remaining inventory could be extremely old and is likely to understate the inventory at today’s prices.

In the end, valuation is more art than science and you can probably see that after following this.

The best way to decide whether a company is being aggressive with inventory valuation is to use common sense and to check out the competitors in the industry. If everyone else is using the LIFO method and company X is the only one using FIFO, then you know you have found a red flag.

For such a simple component of the financial statement, there is quite a lot to think about.

You can also learn more about inventory analysis for investors by following the link.

  • http://www.valuefolio.com Daniel Sparks

    Jae,

    I have really enjoyed the simplicity and clarity of this post.

    I think it is too bad that most companies use FIFO, even though LIFO may drastically understate the value of their inventory.

    However, because LIFO does not overstate earnings as FIFO often does, I would prefer that my businesses use LIFO. I believe it should be the goal of management for the price of their stock to follow the value of a business. Since earnings is Wall Streets beloved number and FIFO has such an aggressive affect on it, I think that FIFO should be avoided.

    Furthermore, as products become obsolete even faster than they did in the past, LIFO is becoming more relevant. For example, in most technology companies old inventory is absolutely worthless. Therefore, it would be hard to over state the value of this inventory even with LIFO. The same is true for clothing retail stores and many other business models.

    I like your suggestion to compare whether or not the company is using LIFO or FIFO with the rest of the industry.

    But here is my question. Where can I quickly find out whether or not a company uses LIFO or FIFO?

  • luca

    There is a website where i can find if a company use a LIFO or FIFO method… (not in the balance sheet)

  • http://seekingalpha.com/author/tim-welland tim

    The company must disclose their method of accounting for inventory in their financial statements. You can often find this one of the first notes to the financial statements, it will be called something like “Significant Accounting Policies.”

    Also worth noting is that a company can use FIFO for their financial report but LIFO for their tax reporting, in order to reduce their taxes payable. This, of course, results in a deferred tax liability, so that is something to watch out for. (the same thing happens with depreciation policies)

  • http://www.oldschoolvalue.com Jae Jun

    @ Daniel and luca
    To quickly find out which method a company uses, go to Edgar and open up the annual report. Then do a quick search for “fifo” or “lifo” and you will get your answer.

  • Dave

    You’re forgetting that behind the numbers there is a real business. The numbers are supposed to reflect reality. There is no business on the face of the earth that actually uses LIFO in inventory management. It makes no sense to put the milk you just bought at the front of the fridge while the one at the back spoils and becomes a biology experiment with tiny little creatures that are spawning and starting to evolve into intelligent beings. That’s the reason that no other country in the world allows the use of LIFO accounting.

    Regarding the difference in COGS. The only reason you got a lower cost of goods with FIFO is because in the example the inventory bought first was cheaper than the inventory bought last. If the first units bought were with a higher cost than the last ones LIFO will give you the lowest COGS and FIFO the highest. It’s far from accurate to say that FIFO is more aggressive, it is accurate to say that FIFO is more realistic.

  • http://www.google.com Amogelang

    What you guys just gave me here is too complicated.I want the LIFO and FIFO methods used in more simple terms, where I can easily understand.

  • http://NIL Salam Afridi

    I am very tired to search on many website, but i have not found that which company is using FIFO OR LIFO, if you have information in this regard Please kindly Tell me…. Your well wisher SALAM AFRIDI

  • http://NIL SANOBER AFRIDI

    where from can i get FIFO, LIFO costing method?

  • http://www.oldschoolvalue.com Jae Jun

    @ Salam,
    If you read the annual reports of the company, it will mention what type of inventory valuation method is being used.

  • Aizharkyn

    Thanks!!! You really helped me! =)

  • Jeff

    Dave, I think you’re reading too much into the FIFO vs. LIFO thing. It is really just a shortcut for an investor to quickly evaluate the conservatism vs. aggression of a company’s managers. That’s it.

    All things being equal, I prefer a company that uses LIFO, because most of the time its GAAP earnings will be lower than a company that uses FIFO.

  • Gill

    Except for their effects on income taxes, inventory methods really do NOT affect PERFORMANCE. During a period of rising prices, a company might report higher profits using FIFO. But that company would not really be any more profitable. An inventory valuation method affects only the ALLOCATION of costs between the inventory account and the COGS account. It has not effect on the total costs actually incurred in purchasing or manufacturing inventory. Except for the amount of income taxes paid, differences in the profitability reported under different inventory methods exist ONLY on paper.

    @ Tim, income tax regulations allow a corporation to use LIFO in its income tax return ONLY if the company also uses LIFO in its financial statements.

    @ Dave, merchandise is always sold based on its respective life expectancy, but that
    doesn’t have anything to do with the flow of inventory costs. Income should be based on current market conditions (current sales revenue offset by the current cost of merchandise); thus, the flow of costs is far more important to determining income rather than the physical flow of the merchandise.

    I do agree with you that LIFO is is more controversial in international settings. In fact, it’s disallowed by the IASB because it leads to outdated inventory numbers in the balance sheet. However, it’s common practice for companies using the LIFO method is to disclose the current replacement cost of the inventory in a note to the financial statements. If the notes are not available and you find it difficult to to revalue inventory numbers, then use the approach that is most conservative.

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