FIFO vs LIFO

First-in, first out vs. Last-in, first out.

These are flow assumptions used in creating the cost of goods portion of the income statement.

In a period of inflation, LIFO will generate a higher cost of sales and lower profit, and since we are generally in a period of inflation, it is often used for income tax purposes because its use will lower a company's tax liability.

Hold on, what do these things mean?

First of all, to use them requires the product remains the same over a period of time. The only change can be the cost associated with the product, period. Any change in the components on the product renders any flow assumption invalid.

FIFO and LIFO are two flow assumptions. Average cost is another, so is specific identification.

FIFO assumes the first product you receive is the first product you sell; they are "queued up", so to speak, in line, just waiting to be shipped. LIFO assumes the last thing you get is the first one you sell; you stack the new goods on top of the old ones and sell from the top of the pile.

So what's the beef? The effect on earnings.

Let's assume you have none at the beginning of the period, then receive 20 at $10, the next week you receive another 40 at $11. The third week you sell 30. How much goes to the cost of sales section of the income statement? Under FIFO, you sold the first 20 plus 10 of the second set, so cost of sales is 20 times $10 plus 10 times $11, or $310. Under LIFO, cost of sales is 30 times $11, or $330. On the average method, you sold 30 out of fifty which had an average cost of $10.60 (20 times $10 plus 30 times $11 = 50 with a total cost of $530. Divided by 50 = $10.60), for a cost of sales hit of $318. In the end, using these amounts as an example and FIFO as a base, the average cost flow assumption results in a cost of sales which is 2.5% higher, while LIFO presents a 6.5% higher cost of sales. It could make a difference in the analysis of results of operation.

All three methods and specific identification are acceptable methods under generally accepted accounting principles and for the IRS (but you have to have permission to switch methods for tax purposes under certain situations).

The advantage of LIFO is that the most current cost of a product is reflected in the income statement; its disadvantages are the costs associated with the required accounting for it, which can become quite complex and are beyond the scope of this article.

Different companies will use different methods to create their income statements and balance sheets and in order to compare the results of companies using different methods, you will need to read and understand the footnotes in order to make the correct adjustment to bring the two companies into some semblance of comparability.

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