Last In, First Out (LIFO) vs First In, First Out (FIFO)
In the field of accounting, LIFO and FIFO are two methods of valuing inventory. LIFO assumes the last items to be acquired are the first to be sold, and the first items to be acquired remain in inventory. FIFO assumes the first items to be acquired are the first to be sold, and the items acquired most recently remain in inventory. Both methods are approved by GAAP.
The idea is that a company accumulates inventory over time, and that the items in inventory were purchased at differing prices. As products are sold, inventory costs move from the balance sheet to the income statement. Accountants have the option of valuing the items sold and the items remaining in inventory according to the oldest or the most recent costs of the inventory.
FIFO and LIFO are merely methods for recording and reporting the cost of inventory and have nothing to do with the actual flow of physical inventory. For example, a company can sell its oldest inventory first, and still use the LIFO method for financial reports.
FIFO Inventory Method
The FIFO inventory method assumes the first items to be acquired are the first to be sold, and the items acquired most recently remain in inventory.
A new firm may want to use FIFO to increase the value of the assets on its balance sheet. Assuming prices rise over time, the oldest inventory will be the cheapest. Expensing the oldest inventory first comparatively decreases the cost of goods sold, increases net income, and increases the value of inventory on the balance sheet because the items remaining in inventory are the most recent and costly items.
LIFO Inventory Method
The LIFO inventory method assumes the last items to be acquired are the first to be sold, and the first items to be acquired remain in inventory.
Using LIFO can have tax advantages. Since prices typically rise over time, the most recent inventory acquired is the most expensive. Expensing the most costly inventory will increase the cost of goods sold and decrease the taxable income this is commonly referred to as the LIFO reserve.
Average Cost Inventory Method
The average cost inventory method is another way to value inventory. This method simply uses the average cost of the items in inventory and uses this cost to value the items that are sold as well as the items that remain in inventory. To calculate the average cost of the inventory, divide total cost of goods available for sale by number of units available for sale.