Inventory management is a
crucial function for any product-oriented business. "First in,
First Out," or FIFO, and "Last in, First Out," or
LIFO, are two common methods of inventory valuation among businesses.
The system you choose can have profound effects on your taxes,
income, logistics and profitability. Here are the major differences
between the two. - See more at:
FIFO
Companies operating on the principle of "First in, First Out" value inventory on the assumption that the first goods purchased for resale became the first goods sold. In some cases, this may not be true, as some companies stock both new and old items.Due to the fluctuations of the economy and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered to be more profitable — at least, on paper. For example, a grocery store purchases milk at regular intervals to stock its shelves. As customers purchase milk, the stockers push the oldest product to the front of the fridge and replace newer milk behind those cartons. The cartons of milk with the nearest expiration dates are thus the ones first sold, whereas the later expiration dates are sold after the older product. This ensures that older products are sold before they perish or become obsolete, and then become profit lost.
Companies that sell perishable products or units subject to obsolescence, such as food products or designer fashions, commonly follow the FIFO method of inventory valuation.
Anil Melwania, CPA with New York accounting firm 212 Tax & Accounting Services, said that because prices rise in the long term, the choice of accounting method can significantly affect valuations.
"FIFO gives us a better indication of the value of ending inventory on the balance sheet, but it also increases net income, because inventory that might be several years old is used to value the cost of goods sold," Melwania told Business News Daily. "Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay."
For businesses needing to impress investors, this becomes an ideal method of valuation, until the higher tax liability is considered. Because FIFO results in a lower recorded cost per unit, it also records a higher level of pre-tax earnings. And, with higher profits, companies can likewise experience higher taxes.
LIFO
The "Last In, First Out" method of inventory entails using current prices to count a measure called "the cost of goods sold," as opposed to using what was paid for the inventory already in stock. If the price of such goods has increased since the initial purchase, the "cost of goods sold" measure will be higher and thereby reduce profits and tax burdens. Nonperishable commodities like petroleum, metals and chemicals are frequently subject to LIFO accounting."LIFO isn't a good indicator of ending inventory value, because the leftover inventory might be extremely old and, perhaps, obsolete," Melwani said. "This results in a valuation much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher. So [there is a] lower taxable income. By using more recent inventory in valuation, your cost basis is higher on current income statements. This reduces gross profit and ultimately net income. This is the implication of LIFO, and many companies prefer LIFO because lower profit reporting means a reduced tax burden."
As an example of how LIFO works, a website development company might purchase a plugin for $30 and then sell the finished product at $50. However, several months later, that asset is increased in price to $35. When the company then writes off profits, it would use the most recent price of $35 as part of LIFO. In tax statements, it would then appear as if the company made a profit of only $15. By using LIFO, a company would appear to be making less money than it actually did, and therefore have to report less in taxes.
The principle of LIFO is highly dependent on how the price of goods fluctuates based on the economy. If a company holds inventory for a long period of time, holding on to product may prove quite advantageous in hedging profits for taxes. LIFO allows for higher after-tax earnings due to the higher cost of goods. At the same time, these companies risk the cost of goods going down in the event of an economic downturn and causing the opposite effect for all previously purchased inventory.
