Inventory management is the backbone of efficient business operations. Managing inventory well can significantly impact your business’s profitability and customer satisfaction. Among the most widely used inventory management methods are LIFO (Last In, First Out) and FIFO (First In, First Out).
In this comprehensive guide, we’ll compare LIFO vs. FIFO to help you decide which method suits your business needs.
Understanding LIFO (Last In, First Out)
The Last In, First Out (LIFO) inventory method is designed for the most recently received products to be used first. Essentially, the most recently acquired items are the first to leave the inventory.
Under LIFO, when you sell a product, you record the cost of the most recent inventory purchased. For example, if you bought 100 units at $10 each and then another 100 units at $12 each, you would record the $12 cost for each unit sold until those units run out, then move to the $10 units.
LIFO is commonly used in industries dealing with non-perishable commodities such as oil, gas, and metals.
Advantages of LIFO
- Lower tax liability (during inflationary periods)
- Easy implementation for recently purchased inventory
- Lower reported income (resulting in lower tax bill)
- Allows companies to claim greater expenses
Disadvantages of LIFO
- Inaccurate inventory movement as older products are used
- Lower net income
- Misrepresentation of the value of the flow of inventory
- Not regulatory compliant in all jurisdictions
- Limited global implementation as prohibited by International Financial Reporting Standards and Canada Revenue Agency regulations
Understanding FIFO (First In, First Out)
The First In, First Out (FIFO) inventory method uses/sells the oldest received inventory first before the newest products. In a warehouse setting, this means the older products are brought to the front of the shelf to ensure they are used/sold before their expiry.
Under FIFO, when you sell a product, you record the cost of the oldest inventory purchased. For example, if you bought 100 units at $10 each and then another 100 units at $12 each, you would record the $10 cost for each unit sold until those units run out, then move to the $12 units.
This approach is commonly used in sectors that involve perishable goods such as pharmaceuticals and food/beverages.
Advantages of FIFO
- Higher net income
- Higher inventory balances
- Promotes regular inventory turnover
- Prevents stock from becoming outdated
- Higher gross income and profits reporting
- Accurate inventory value count
Disadvantages of FIFO
- Higher tax liability (during inflationary times)
- Inaccurate cost of materials with stagnant inventory
- Exaggerate profits (due to the gap between costs and revenue)
- High reported income (resulting in a higher tax bill)
Key Differences Between LIFO and FIFO
- Inventory Valuation: The FIFO method offers a more accurate value indicator as the most recent inventory falls under the current market price. In the LIFO system, a large percentage of the inventory must be considered under the current value.
- Cost of Goods Sold (COGS): LIFO generally results in higher COGS during inflation, lowering taxable income. FIFO results in a lower COGS, increasing taxable income but providing a more stable measure of profitability.
- Tax Implications: LIFO offers tax advantages during inflationary periods by reducing taxable income. FIFO, while simpler, may result in higher tax liabilities but offers more consistent financial reporting.
- Financial Reporting: LIFO can distort financial reporting due to outdated inventory values on the balance sheet. FIFO provides more accurate and transparent financial reporting, reflecting current market conditions.
- Compliance and Global Considerations: LIFO is accepted under Generally Accepted Accounting Principles (GAAP) but not under International Financial Reporting Standards (IFRS), limiting its use for international businesses. FIFO is accepted under both GAAP and IFRS, making it more universally applicable.
Factors to Consider When Choosing Between LIFO and FIFO
- Industry and Type of Products: As FIFO is best suited for inventory with a limited shelf life, this inventory management system is frequently used for foods, medication, and cosmetic products. Some businesses depend on the LIFO system for building materials, clothing, and automobiles.
- Economic Environment: The impact of inflation or deflation plays a role in which inventory management system is being used. With inflation periods, the gross profit margin can rise as older inventory that was cheaper than the latest inventory is priced up. Deflation can see less of a profit as lowering prices on all inventory sees a loss on the latest (and more costly) inventory received.
- Business Goals and Financial Strategy: In aligning inventory methods with broader financial objectives, the LIFO system helps to decrease tax liability. If accurate financial reporting is critical, FIFO may be the better option.
- Regulatory Compliance: As North American companies are required to comply with the Generally Accepted Accounting Principles (GAAP) for financial statements, it is important to ensure the chosen method is also in compliance.
Making the Decision: LIFO or FIFO?
Choosing between LIFO and FIFO is a critical decision that should align with your business model, market conditions, and financial goals. Consider the nature of your products, the economic environment, and your overarching business strategy.
Consulting with financial and supply chain experts can provide additional insights and help you make an informed decision.
Contact Lean Supply Solutions for Personalized Inventory Management Solutions
Lean Supply Solutions utilizes the latest technology and cloud-based software to optimize your supply chain management system. Our inventory management solutions can save you time and money by streamlining your business’s needs and staying ahead of potential issues.
Speak to one of our consultants for more information on how our inventory management systems and other 3PL/4PL services can help you!
