FIFO vs. LIFO: Which Inventory Accounting Method is Best for Manufacturers?

For manufacturers, inventory accounting is a key component of financial management because it plays an integral role in financial reporting, profitability, and cost monitoring. Proper inventory accounting allows manufacturers to assess the value of raw materials, work-in-progress, and finished products, which thereby enables production planning and cost control. Two of the most common inventory accounting methods are FIFO (first-in, first-out) and LIFO (last-in, first-out).

Under period-end inventory accounting, LIFO assumes that the last items purchased or produced are the first to be used, and FIFO assumes the opposite. Each method has its impact on the cost of goods sold (COGS), inventory valuation, and taxes, so it is crucial for manufacturers to choose the method that aligns with their business strategy and financial goals.

What is inventory accounting?

For manufacturers, inventory accounting is a key aspect that enables the tracking and valuation of raw materials, WIP (work-in-progress), and finished products. Such tracking helps in accurate reporting of finances, controlling costs and maintaining an effective inventory.

Manufacturers use inventory accounting to determine the Cost of Goods Sold (COGS), assess profitability, and comply with tax regulations. Tracking and updating business stock helps businesses streamline the production planning process while avoiding shortages or oversupply of items and making sure they know what they have on hand. Proper inventory accounting will also affect financial statements, which ultimately impact key performance ratios, such as gross profit and net income.

In manufacturing, FIFO (First In, first Out) and LIFO (Last In, first Out) are the two major methods of valuing inventories. The treatment of each strategy in consideration of COGS, tax obligations, and overall financial health are all notably contrasting. Understanding these methodologies is essential for manufacturers to make decisions aligned with their business goals and regulatory responsibilities.

Inventory Accounting Methods for Manufacturers

For manufacturers, inventory accounting is essential to track the costs related to raw materials, work-in-progress (WIP), and finished products. The selected accounting method for inventory affects the cost of goods sold (COGS), inventory valuation, taxes, and financial statements.

FIFO vs LIFO for Manufacturers

Manufacturers use the following methods of inventory accounting:

FIFO Accounting Method (First-In, First-Out)

FIFO is based on the principle that the oldest inventory (the first to be bought or produced) is sold or used first, and the newest inventory sits in storage.

The Operation of FIFO:

When a sale is made, the cost of the oldest inventory will be posted to the cost of goods sold (COGS).

The remaining inventory on the balance sheet is comprised of recently acquired products.

FIFO inventory method advantages:

• FIFO allows current market prices to be included in the inventory valuation.
• Inflates reported profits in times of price inflation
• Follows both GAAP and IFRS accounting standards
• Applicable for perishable items or products with an expiry date.
• In inflation, lower COGS means more unrecognised taxable income.
• It might not be helpful in industries that are rising in costs.

LIFO Accounting Method (Last-In, First-Out)

What It Is: LIFO denotes that the most recent inventory costs are used for sale or consumption, while older inventory remains on hand.

• COGS is recorded with the cost of the latest inventory first.
• Older, cheaper inventory stays on the balance sheet.

LIFO inventory method advantages:

Higher cost of goods sold (COGS) during inflationary times, thus lowering taxable income.

Minimises tax responsibilities, thus enhancing cash flow.

Suitable for industries that face volatility in costs,, like oil, metals, and basic materials.

Disadvantages of LIFO:

• N/A IFRS; permissible U.S. GAAP.
• Underappreciated inventory then appears on the balance sheet.
• Investor confidence can be shaped by the lower reported profits.

Weighted Average Cost (WAC) Method: 

WAC finds the average cost of all the inventory items available in a certain period and applies that average cost to the cost of goods sold (COGS) and to the ending inventory.

The Operation of WAC:

The weighted average principal cost is determined by dividing the total cost of all stock by the total number of units.

This per-unit cost flows through in revenue, too, impacting inventory valuation and cost of goods sold (COGS).

WAC provides the following benefits: 

• It reduces the variation in costs you might incur on inventory.
• Reduces the impact of sudden price changes on financial records.
• This is most suitable for bulk inventory that can be easily applied.

One of WAC’s disadvantages is that it can result in inaccurate results in sectors with significant cost variability between orders. It does not reflect specific inventory cost layers (e.g., FIFO, LIFO).

Specific Identification Method: 

This method tracks and assigns the exact cost to each inventory item. It is mainly used for goods that are uniquely identifiable or valuable.

Specific identification mechanism:

• Each element is assigned its actual cost of inventory.
• When the unit is sold, the accurate cost of the unit appears in the recorded COGS.

Advantages of Specific Identification: 

• Provides the most accurate inventory valuation.
• It is best suited for companies that manage valuable items, including automobiles, jewelry, and art.
• Helps in the exact calculation of taxes and profits.

Disadvantages of specific identification: 

• For large inventories, businesses are faced with relatively complex and time-consuming processes.
• Not doable for suppliers with high inventory turnovers
• How FIFO and LIFO Accounting Affect Financial Statements

How FIFO and LIFO Accounting Affect Financial Statements

FIFO (first-in, first-out) and LIFO (last-in, first-out) can further escalate significantly to affect the income statement, balance sheet, and cash flow statement. The difference between the two impacts important financial measures in your business, including net income, inventory valuation, tax liabilities, and cost of goods sold (COGS).

Impact on Income Statement

The income statement reflects the profitability of the company and is impacted by FIFO and LIFO via the net income as well as the COGS.

FIFO: 

Accounts for older inventory (usually lower cost) in calculating COGS

So, with inflation, you have lower COGS, higher gross profit, and higher net income.

More profits mean more tax liabilities.

Great for firms that want to showcase strong profitability.

LIFO: 

It has been using the newer and usually more costly inventory for calculating its COGS.

As a result of this, inflation increases the cost of goods sold (COGS), which affects net income and gross profit.

So, there are reduced profits, which can lead to fewer taxes, which can be good for tax purposes.

Helps manufacturers manage tax obligations, but this may result in reduced profitability.

Effect on the Balance Sheet

Depending on FIFO and LIFO, the company has an inventory value on the balance sheet, which will vary with these accounting methods.

FIFO:

The latest (higher-cost) purchases make up ending inventory, which gives a truer market value.

The balance sheet reflects a stronger financial position because inventory is costed at current costs.

Investors and creditors are attracted due to realistic inventory valuation.

LIFO: 

The inventory that is at the end of its life cycle is frequently undervalued due to the fact that it is composed of previous, lower-cost purchases.

The company’s value may be diminished as a result of the fact that inventory valuation may not accurately reflect current market conditions.

This can result in an obsolete asset valuation, which can be detrimental to financial reporting.

Effect on Cash Flow and Taxes

FIFO:

This reduced financial flow is due to higher tax liabilities that accompany the growth of net income.

But corporate taxpayers might have to reserve more cash to pay taxes, which could hurt liquidity.

Last-In-First-Out:

Reducing net income lowers tax liability and improves cash flow.

LIFO allows companies to store extra capital for use in operations and investments.

However, in case of price decline, LIFO will lead to higher taxable income due to lower COGS.

Key Differences and Considerations Between FIFO and LIFO

Among the essential aspects where FIFO and LIFO differ are inventory value, taxes (WHT), and the cost of goods sold (COGS). By expensing older inventory first, FIFO generally produces lower COGS in periods of price growth compared to LIFO, causing higher reported profits and thus tax obligations. Conversely, LIFO records the most recent inventory costs as COGS, leading to higher expenses and lower taxable income during periods of inflation.

From an inventory valuation perspective, FIFO provides a more accurate view of current market prices, leaving the newer inventory on the balance sheet. This approach is used and accepted under both IFRS and GAAP and increases transparency in the financials. On the other hand, LIFO does not provide an accurate depiction of the stock value as it pulls out older stock with lower purchase costs, which may lead to an understatement of the real estate of the organization.

Tax considerations also play a major role in the decision-making process. Adopting it would thus be a feasible alternative for companies in locations allowing LIFO (where the United States is included in this regard). FIFO remains the method of choice for IFRS-compliant organisations, allowing them to stay compliant with regulations.

Choosing FIFO or LIFO for manufacturing 

When manufacturers choose a cost accounting system, they face an important choice between FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) that impacts their overall business strategy, tax exposures, and financial statements. Factors supporting this decision include marketplace state, financial objectives, regulatory observance, and product types you are going to sell.

Critical Factors to Evaluate

A. The Products 

The properties of FIFO is optimal for perishable or time-sensitive products like food, pharmaceuticals, and chemicals.

• Minimizes waste and spoilage by promoting older stock for sale.
• Provides a more accurate view of inventory cost.
• For long-lasting, non-perishable goods like raw ores, electronics, and metals, LIFO is better.
• This information helps manage inflationary cost increases as increases in costs are aligned with revenues.
• This is especially useful for industries where the cost of raw materials fluctuates.

B. Inflation & market conditions

• In stable or deflationary market conditions where prices are stable or tend to fall, first in, first out is used.
• If prices do not change, it translates to higher profits and lower cost of goods sold.
• In times of inflation, the LIFO indicates that the price of basic material and production expenses lifts reported profits.
• Under this method, because COGS now reflects the cost of the most recent inventory, which is typically more expensive, taxable incomes are reduced as well.
• Helping manufacturers cut tax expenditures in times of inflation

C. Financial Reporting and Compliance

• FIFO: The industry standard for global manufacturers is FIFO. The industry standard for global manufacturers, as well as FIFO, is accepted under both IFRS and GAAP.
• Easier to pull off and widely recognized by regulators and investors.
• LIFO may only be used under U.S. GAAP and not under IFRS.
• International manufacturers may not be able to use LIFO.
• Manufacturers should consider their financial goals, tax strategies, inventory types, and compliance before choosing between FIFO and LIFO.
• When it comes to financial transparency, global compliance, and accurate inventory valuation, FIFO is the best approach for organizations.
• LIFO is an appropriate solution for businesses that are currently applying U.S. GAAP, working on reducing taxable income, and faced with cost inflation.

However, longer-term financial objectives, the state of the economy, and industry dynamics all influence whether or not a new model is introduced. Companies might consider hybrid approaches or some other inventory accounting method, like weighted average cost (WAC) or specific identification.

In conclusion,

FIFO and LIFO are concepts that must be understood by manufacturers, as they directly affect profitability, tax liabilities, and financial statements. It means that LIFO is beneficial from the tax perspective when it comes to inflation, whereas FIFO valuation corresponds better with international accounting standards and gives an accurate figure of the stock value. The particular method chosen will depend on the nature of the product and the relevant market and regulatory context. By evaluating these elements and making adjustments accordingly, manufacturers can improve financial performance and maintain compliance.

FAQs

1. What is the difference between FIFO and LIFO inventory accounting?

FIFO (First-In, First-Out): Products are sold in the order they were purchased, so older and usually lower-cost goods are included in COGS.

LIFO (Last-In, First-Out): The latest inventory is sold first, so the COGS includes newer and usually higher-cost items.

2. What impact does FIFO have on the cost of goods sold (COGS)?

Uses old and cheap inventory in the COGS

During inflation, lower COGS leads to both higher profits and higher taxable income.

3. How do FIFO and LIFO affect financial statements?

FIFO: Provides a more accurate inventory value in the balance sheet since this type of inventory is newer and in stock.

LIFO: Reports higher COGS and lower profits during inflation, resulting in a reduction in taxable income but an undervaluation of inventory.

4. How does LIFO impact tariffs for manufacturers?

Compared with FIFO, LIFO reports higher COGS in inflationary environments, which in turn reduces taxable income.

This technique allows manufacturers to save taxes, which leads to a decrease in tax liabilities.