Understanding the Difference Between FIFO and LIFO

A few items in basic accounting of inventory need to be addressed before explaining the differences between the cost flow assumptions: First In, First Out (FIFO) and Last In, First Out (LIFO).

First, effective planning and control of inventory are needed to improve entities profits. Excessive inventory balances at the end of a fiscal period can lead to obsolete inventory practically useless items for production and sales. On the other hand, insufficient inventory can result in missed opportunities in sales.

Now to account for inventory records, manufacturing and sales entities use either a perpetual inventory system or a periodic inventory system. Under the perpetual inventory system quantities are known at any time. Totals are calculated each time goods are purchased, used or sold. The company knows at all times how much remains in inventory. Under the periodic inventory system companies figure the ending balance periodically, usually at the end of each month.

At this point you probably wonder, "What about the cost of these inventories?" It is very likely that companies purchase goods several times at different prices during a fiscal period.

To come near a single price of the goods a cost flow assumption is adopted for the perpetual or periodic inventory system. First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) are two such cost flow assumptions that can be used to account for the cost of the inventory.

FIFO METHOD:
FIFO assumes the entity uses the goods in the order in which they were purchased or acquired. This means that the first items purchased are recorded as the first items used, or sold as in the case of a retail company. This does not mean that the first purchases were actually used or sold they are just entered in the inventory records as if they were. Of course, the inventory remaining at the end of a period would represent the most recent purchases.

In all instances where FIFO is implemented, the costs of goods sold are the same at the end of the month whether a perpetual or periodic system is used. This is because the same costs will always be the first in and therefore the first out.

An advantage of FIFO is that ending inventory is stated in as close an estimate of current costs. Because the first goods acquired are the first out, the ending inventory amount is composed of the most recent purchases. It is clear that this method does not manipulate

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