FIFO and LIFO: Which is Best for Stock Valuation?

By LM Team Writer – 11 October 2024

In the intricate world of inventory management, three methods stand out as key players in determining stock valuation: FIFO and LIFO (First In First Out method) and (Last In First Out) and Weighted Average Cost (AVCO). Each method has its unique approach to inventory valuation, influencing not just how businesses report their earnings, but also their tax obligations and cash flow. FIFO operates on the principle that the oldest stock is sold first, reflecting a more accurate depiction of market value during times of rising prices. In contrast, LIFO suggests that the most recently acquired inventory is sold first, potentially shading a company’s profitability against inflation, Weighted average cost (AVCO) suggests cost of goods sold and ending inventory is determined by averaging the cost of all units purchased during a period. This method assumes that all units are a mix of the units purchased at different prices.

In this blog post, we’ll explore the advantages and disadvantages of these inventory valuation methods, equipping you with the knowledge to choose the best approach for effective stock valuation in your business. Whether you’re new to inventory strategies or looking to refine your existing processes, understanding FIFO, LIFO and weighted average cost (AVCO) will provide insights critical to your financial decision-making.

Inventory Valuation Example: FIFO and LIFO and AVCO

FIFO: First In First Out Method

The (FIFO) First in first out method assumes that the oldest inventory items are sold first. This approach mirrors common business practices and is particularly useful in industries where products have a limited shelf life. We’ll delve into how FIFO impacts stock valuation, profitability metrics, and even the tax implications for your business.

Using the first in, first out assumption, 9,000 tonnes of the 10,000 tonnes bought on 10 Sep are treated as if these are the ones to be sold. The remaining inventories bought on 10 Sep (1,000 tonnes) and the inventories bought on 15 Sep (20,000 tonnes) will become the closing inventories. Thus we have:

(FIFO) Valuation Method

LIFO: Last In First Out

On the flip side, LIFO “last in first out” assumes that the newest inventory items are sold first. This method can be advantageous in times of rising prices, as it can reduce tax liabilities by lowering reported profits. We will explore how the LIFO method affects inventory valuation and financial statements, revealing the potential pros and cons associated with using this approach.

Using the last in, first out assumption, 9,000 tonnes of the inventories bought on 15 Sep will be treated as if these are the first to be sold. The earlier inventories bought on 10 Sep (10,000 tonnes) and the remainder of the inventories bought on 15 Sep (11,000 tonnes) will become the closing inventories. Thus we have:

(LIFO) Valuation Method

AVCO: Weighted Average Cost

On the flip side, LIFO “last in first out” assumes that the newest inventory items are sold first. This method can be advantageous in times of rising prices, as it can reduce tax liabilities by lowering reported profits. We will explore how the LIFO method affects inventory valuation and financial statements, revealing the potential pros and cons associated with using this approach.

Under this assumption, newly acquired inventories are treated as if they lose their separate identity. A weighted average cost, based on the quantities of each batch purchased, is calculated. The weighted average cost is then used to derive both the cost of goods sold and the cost of remaining inventories held. This simply means that the cost of the inventories bought on 10 Sep and 15 Sep are added together and then divided by the total number of tonnes to obtain the weighted average cost per tonne. That is:

Average Cost = ((10,000 * $10) + (20,000 * $13))/(10,000 + 20,000) = USD 12 per tonne

(AVCO) Valuation Method

Suppose that the 9,000 tonnes of inventories in the above example were sold for $15 a tonne.

(A) Calculate the gross profit for the period under each of the three costing assumptions.

(B) What do you note about the different profit and closing inventories valuations when using each method, when prices are rising?

The answer should be along the following lines:

(a) Gross profit calculation:

(B) The closing inventories valuations of each method:

These figures show that FIFO will give the highest gross profit during a period of rising prices. This is because sales revenue is matched with the earlier (and cheaper) purchases.
LIFO will give the lowest gross profit because sales revenue is matched against the more recent (and dearer) purchases.
The AVCO assumption will normally give a figure that is between these two extremes.
The closing inventories figure in the statement of financial position will be highest with the FIFO assumption. This is because the cost of oil still held will be based on the more recent (and dearer) purchases. LIFO will give the lowest closing inventories figure, as the oil held will be based on the earlier (and cheaper) purchases. Once again, the AVCO assumption will normally give a figure that is between these two extremes. During a period of falling prices, the position of FIFO and LIFO is reversed.

Pros and Cons of FIFO and LIFO

FIFO Pros :

The biggest advantage is that it ensures older inventory is sold first, which helps prevent the risk of obsolescence. This method is particularly suitable for businesses dealing with perishable goods or products with expiry dates. By selling older inventory first, FIFO can also help maintain product freshness and quality. Additionally, FIFO provides a more accurate representation of inventory costs, as it matches recent purchasing prices with current sales revenue.

FIFO Cons:

However, FIFO does have its downsides. One of the main challenges is the potential for inventory valuation issues during periods of rising costs. Since older inventory is sold first, the cost of goods sold (COGS) may not reflect the current market value, which can impact profitability and financial reporting accuracy. Furthermore, in industries with frequent product updates or technological advancements, FIFO may lead to a buildup of outdated inventory, affecting cash flow and storage capacity.

LIFO Pros:

On the other hand, (LIFO) last in first out has its own set of advantages and disadvantages. LIFO allows businesses to match current inventory costs with revenue, providing a more accurate representation of profitability. This method can be beneficial in inflationary environments, as it results in a higher COGS, which reduces taxable income and potentially lowers tax liabilities.

LIFO Cons:

LIFO also has drawbacks. One of the main challenges is the potential for inventory obsolescence, as older inventory remains in stock for longer periods. This can lead to increased holding costs and the risk of having outdated or unsellable items. Additionally, LIFO may not reflect the true cost of inventory, as newer, potentially higher-priced inventory remains in stock.

Ultimately, choosing between FIFO and LIFO depends on various factors, including the nature of the business, industry trends, and financial goals. It is essential for businesses to carefully evaluate the pros and cons of each method and consider their specific circumstances before implementing an inventory management strategy.

Frequently Asked Questions

The Bottom Line

We hope you found our blog post on FIFO and LIFO helpful in understanding the different inventory management methods and choosing the right one for your business. The choice between FIFO and LIFO for stock valuation depends largely on your specific business needs and objectives. FIFO generally provides a more accurate representation of market value, especially during periods of rising prices. It also aligns with the natural flow of inventory in many industries. However, LIFO can be advantageous for tax purposes, particularly in times of inflation.
Ultimately, the best method for your business will depend on factors such as:
Industry:
Certain industries may be more suited to one method over the other. For example, industries with perishable goods often use FIFO.
Tax implications:
The tax consequences of using FIFO or LIFO can vary depending on your location and specific circumstances.
Financial reporting goals:
Your choice may be influenced by how you want to present your company’s financial performance.

It's important to note that before making any decisions based on the information in this blog post, you should consult with a financial professional to get personalized advice.