FIFO and LIFO: Which is Best for Stock Valuation?

By LM Team Writers – 11 October 2024

Introduction

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 systems, influencing how businesses report their earnings, 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 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 the 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 in logistics management.

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

This presumption treats recently acquired inventory as though they no longer have a distinct identity. Based on the amounts of each batch that is purchased, a weighted average cost is calculated. The cost of goods sold and the cost of remaining inventory are then calculated using the weighted average cost. 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) Determine the gross profit for each of the three costing assumptions for the given time.

(B) When employing each technique, what observations do you make on the disparities in closing inventory and profit values during periods of rising prices?

The response needs to be something like this:

(a) Gross profit calculation:

(B) Each method’s closing inventory valuations:

These numbers demonstrate that when prices are rising, FIFO will yield the largest gross profit. This is because the earlier (and less expensive) purchases are balanced by sales income.
Because sales income is matched against the more recent (and more expensive) purchases, LIFO will result in the lowest gross profit.
Usually, the AVCO assumption will provide a number in the middle of these two extremes.

The FIFO assumption will result in the greatest closing inventory number in the statement of financial condition. This is due to the fact that the price of oil that is still retained will be determined by the more recent (and more expensive) acquisitions. Because the oil kept will be based on the earlier (and less expensive) purchases, LIFO will provide the lowest closing inventory number. Once more, the AVCO assumption often yields a value in the middle of these two extremes. The FIFO and LIFO positions are inverted at a time of declining pricing.

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

What are the primary inventory valuation methods used in accounting?

FIFO (First-In, First-Out)
LIFO (Last-In, First-Out)
Weighted Average Cost (AVCO)

How does each method approach the valuation of inventory?

FIFO: The oldestThe newest inventory is sold first.
LIFO: Newest inventory is sold first.
AVCO: All inventory is assumed to be a mix of units purchased at different prices.

What are the advantages of using the FIFO method?

Matches current costs with current revenues.
More accurately reflects the market value of inventory during rising prices.
Aligns with common business practices, especially for perishable goods.

What are the potential disadvantages of using the FIFO method?

This can result in higher income taxes during periods of rising prices due to higher reported profits.
May not accurately reflect the cost of goods sold if prices are fluctuating.

What are the advantages of using the LIFO method?

Can reduce income taxes during periods of rising prices due to lower reported profits.
Can reduce income taxes during periods of rising prices due to lower reported profits.
Can provide a better match of current costs with current revenues in industries with rapidly changing prices.

What are the potential disadvantages of using the LIFO method?

May not accurately reflect the market value of inventory.
Can lead to understated profits during periods of rising prices.
Can provide a better match of current costs with current revenues in industries with rapidly changing prices.

What are the advantages of using the AVCO method?

Provides a smoother flow of costs through the income statement.
Less susceptible to fluctuations in prices compared to FIFO or LIFO.

What are the potential disadvantages of using the AVCO method?

May not accurately reflect the market value of inventory.
Can be more complex to calculate than FIFO or LIFO.

Which method is best for your business?

The choice depends on factors such as industry, pricing trends, tax implications, and management preference.

Can a company use different methods for different inventory items?

The choice depends on factors such as industry, pricing trends, tax implications, and management preference.

How can you choose the method that best aligns with your business goals?

Consult with an accountant or tax advisor to evaluate the potential benefits and drawbacks of each method.

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.

FIFO and LIFO: Which is Best for Stock Valuation?

Introduction

Table of Contents