LIFO (which is the acronym for Last In, First Out) is a cost flow assumption in which the most recent costs of inventory items are the first costs to be removed from inventory and reported as the
cost of goods sold. As a result, the older costs remain in inventory. FIFO (which is the acronym for First In, First Out) is a cost flow assumption in which the oldest costs of inventory items are the first costs to be removed from inventory and reported as the cost of goods sold. As a result, the most recent costs remain in
inventory. Net sales - Cost of goods sold = gross profit? If there were no changes in the cost of inventory items (purchased or manufactured), there would be no difference between
the LIFO and FIFO cost flows. Since costs have historically increased, the latest or most recent costs are higher than the older costs. When the recent higher costs are removed from inventory and reported as the cost of goods sold on the income statement, the resulting gross profit will be lower. If the corporation ends up with lower taxable income, it likely means lower income tax expense. ABC Store purchases a product and then sells
them to its retail customers. ABC began on January 2 and purchased 1 unit of product in each of the following months at these costs: $10 in January, $12 in April, $13 in October. Therefore, ABC's cost of goods available amounted to $35. Next, assume that 2 units were sold and 1 is in inventory on December 31. Also assume that the retail price remained constant at $16 each.Definition of LIFO
Definition of FIFO
Definition of Gross Profit
Difference between LIFO and FIFO
Example Comparing LIFO and FIFO
Using the LIFO cost flow assumption, the cost of the 2 units sold will be $25 ($13 + $12)
Using the FIFO cost flow
assumption, the cost of the 2 units sold will be $22 ($10 + $12)
Gross profit using LIFO: Sales of $32 - COGS $25 = $7
Gross profit using FIFO: Sales of $32 - COGS $22 = $10
Note that the LIFO gross profit is $3 less than the FIFO gross profit.
Inventory includes raw materials, partially finished goods and finished goods. A retail business may have finished goods awaiting shipment, while a manufacturing business may have raw materials and partially completed products that require further processing before sale. The choice of an inventory valuation method affects the calculation for cost of goods, which affects gross profit and net income.
Basics
The perpetual system tracks each purchase and sale, which continually updates the inventory balance and cost of goods. The periodic system relies on physical inventory counts and cost of goods estimates for inventory balances because it does not track inventory continually. The common inventory valuation methods are first-in first-out (FIFO), last-in first-out (LIFO), weighted average and specific identification. Inventory costs include acquisition, shipping and direct labor costs.
FIFO
The FIFO valuation method assumes that the first inventory item purchased is the first one used in production or sold. For example, if a small business has 10 items in stock worth $10 each and it purchases 10 additional items for $12 each, the FIFO method would assume that items in the first sales transaction come from the $10 lot. In an inflationary environment, the cost of goods includes the less expensive items while ending inventory includes the more expensive items. This means that the net income and ending inventory amounts are higher under the FIFO method. However, in a deflationary environment, the FIFO method is likely to generate lower net income.
LIFO
The LIFO valuation method assumes that the last inventory item purchased is the first one used in production or sale. Continuing with the earlier example, the LIFO method would assume that items in the first sales transaction come from the latter $12 lot. In an inflationary environment, the cost of goods includes the more expensive items while ending inventory includes the less expensive items. This means that the net income and ending balance amounts are lower under the LIFO method. However, when prices are falling, the LIFO method is likely to generate higher net income.
Weighted Average
The weighted-average method divides the total purchase costs by the number of units in inventory to compute the average unit cost. For example, the average unit cost for purchases of 10 units at $100 each and 20 units at $50 each is 10 multiplied by $100 plus 20 multiplied by $50 -- which is $2,000 -- divided by 10 plus 20, or about $67. The weighted-average costs are directly proportional to the purchase costs. Therefore, in a rising price environment, the average unit costs are higher and net income is lower, while the opposite is true in a falling price environment.
Specific Identification
The specific identification method tracks the exact cost of each inventory item. The effect on net income depends on changes in the acquisition costs of the inventory items. However, this method is not practical for businesses with hundreds of different items in stock.