by Juan Leer

Created on: January 28, 2007   Last Updated: September 25, 2009

One key issue for businesses to account for is how they account for the inventory that they sell. In order to properly determine their profits, and the cost of goods sold, they need to come up with a way that they will consistently measure that sold inventory, so that they can properly measure things and make sure there is consistency in their financial statements.

While there are some companies that use methods such as average cost, or specific identification (if they aren't selling as many items or have a smaller business), in general they used either the LIFO method of the FIFO method. Whenever they sell any of their inventory, they use one of these two methods to figure out how much money they paid for, which lets them know how much they made or are making. There are many differences between these two methods.

FIFO = First In, First Out
LIFO = Last In, First Out

It is probably easiest to explain these concepts using a concrete example with numbers. So let's say you're a paper company, and you receive these shipments:

January 1 - 10 boxes of paper for $200
January 15 - 10 boxes of paper for $100

Next, let's say that on February 1, someone buys 10 boxes of paper for $300. Here's what would happen:

FIFO - you would consider the boxes bought on January 1 to be sold, since they were first in (and will be first out), so your gross profit would be $100 ($300-$200).
LIFO - you would consider the boxes bought on January 15 to be sold, since they were last in (and will be first out) so your gross profit would be $200 ($300-$100).

LIFO is generally considered a more accurate representation of profit because that is closer to the prices it would take to replace the inventory lost. But FIFO can keep you from having outdated inventory numbers, which can lower the amount of assets that you have recorded on your books, which is not an idea that is appealing to a company. But you can do it either way as a company, just so long as you remain consistent so you keep the financial statements consistent.

In a time where the cost of inventory is rising, using the LIFO method will lower your net income because it will increase the cost of goods sold. The opposite is true if the cost of inventory is lowering... in that case, using the LIFO method will raise your net income because the decrease the cost of goods sold.

That is LIFO and FIFO in a nutshell.

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