How LIFO and FIFO impact a firm's inventory outlook
Do you sometimes evaluate your firms, but don't look at how they account for their inventory?
For many businesses, inventory represents an enormous, if not the vastest, a portion of their assets.
As a result, inventory is an important element of the balance sheet. Accordingly, significant investors must understand how to evaluate the inventory line item when comparing companies across businesses or in their portfolios.
What Is Inventory?
In general, when we talk about inventory, we are referring to a company's goods in three stages of production:
1) goods that are raw materials.
2) goods that are in production.
3) goods that are finished and available for sale.
In other words, you take the goods that the company has in the beginning, add the materials that it purchased to make more goods, deduct the goods that the company sold, cost of goods sold (COGS), and the result is what remains—inventory.
Inventory accounting assigns values to the goods in each production phase and categorizes them as company assets, as inventory can be sold, accordingly turning it into cash shortly. Assets need to be accurately estimated so that the company as a whole can be accurately valued. The formula for calculating inventory is:
Begging inventory + Net purchase – COGS = Ending Inventory.
Understanding LIFO and FIFO
The accounting method that a company uses to specify its inventory costs can have an immediate effect on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows.
The U.S. generally accepted accounting principles (GAAP) allow enterprises to use one of many inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO).
First-In, First-Out (FIFO)
The First-In, First-Out (FIFO) method assumes that the first unit obtaining its way into inventory–or the oldest inventory–is sold first. For instance, let's say that a Factory produces 400 units in January for $2 each, and 400 more in February at $2.25 each. FIFO states that if the factory sold 400 units in March, the COGS (on the income statement) are $2 per Unit because that was the cost of each of the first loaves in inventory. The $2.25 Units would be allocated to ending inventory (on the balance sheet).
Last-In, First-Out (LIFO)
The Last-In, First-Out (LIFO) method assumes that the last or more units to obtain in inventory is sold first. The older inventory, thus, is left over at the end of the accounting period. For the 400 Units sold in March, the same Factory would assign $2.25 per Unit to COGS, while the remaining $2 Units would be used to compute the value of inventory at the end of the period.
LIFO vs. FIFO: Inventory Valuation
The valuation method that a firm uses can vary across several industries.
Beneath are some of the differences between LIFO and FIFO when considering the valuation of inventory and its impact on COGS and profits.
LIFO
Since LIFO uses the most newly obtained inventory to value COGS, the leftover inventory might be too old.
As a result, LIFO doesn't contribute an accurate or up-to-date value of inventory because the valuation is largely lower than inventory items at today's prices. Furthermore, LIFO is not realistic for many businesses because they would not abandon their older inventory standing idle in stock while using the most newly acquired inventory.
For instance, a business that sells seafood products would not use its newly-acquired inventory first in selling and shipping its products.
In other words, the seafood the company would never leave their oldest inventory sitting idle since the food could spoil, leading to losses.
In conclusion, LIFO isn't logical for many businesses that sell perishable goods and doesn't accurately indicate the reasonable production process of using the oldest inventory first.
FIFO
FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most previously obtained items indicate current market prices. For most businesses, FIFO is the most reasonable option since they generally use their oldest inventory first in the production of their goods, which means the valuation of COGS indicates their production plan.
For instance, the seafood firm referred firstly, would use their oldest inventory first (or first in) in selling and shipping their products. Since the seafood company would never leave older inventory in stock to spoil, FIFO accurately indicates the firm's process of using the oldest inventory first in selling their goods.
LIFO and FIFO: Impact of Inflation
If inflation were nonexistent, then all three of the inventory valuation methods would produce the same conclusions. Inflation is an estimate of the rate of price increases in an economy. When prices are stable, our Factory illustration from earlier would be able to produce all of its bread Units at $2, and LIFO, FIFO, and average cost would give us a cost of $2 per Units. Nevertheless, in the real world, prices tend to rise over the long term, which means that the option of accounting method can affect the inventory valuation and profitability for the period.
Assuming that prices are rising, inflation would impact the two inventory valuation methods as follows:
LIFO
When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later.
In an inflationary climate, the current COGS would be higher under LIFO because the new inventory would be more costly. In conclusion, the company would record lower profits or net income for the period. But, the smaller profit or earnings means the company would benefit from lower taxes.
FIFO
When sales are recorded using the FIFO method, the oldest inventory–that was obtained first–is used up first. FIFO leaves the recent, more expensive inventory in a rising-price climate, on the balance sheet. As a result, FIFO can increase net income because inventory that might be many years old–which was acquired for a lower cost–is used to value the Cost of goods sold. But, the higher net income means the company would have a higher tax liability.
Illustration of LIFO vs. FIFO
In the tables below, we use the inventory of an imaginary beverage producer called moonlight canning Company to see how the valuation methods can cause the outcome of a firm’s financial analysis.
The company made inventory purchases each month for Q1 for a total of 6,000 units. However, the company already had 2,000 units of older inventory that was purchased at $16 each for a $32,000 valuation.
In other words, the beginning inventory was 8,000 units for the period.
The company sold 6,000 units in Q1, which left an ending inventory balance of 2,000 units or (8,000 units - 6,000 units sold = 2,000 units).
Cost of goods sold Valuation
• Under LIFO, COGS was valued at $150,000 because the 6,000 units that were purchased most newly were used in the computation or the January, February, and March purchases ($40,000 + $50,000 + $60,000).
• Under FIFO, COGS was valued at $122,000 because FIFO uses the oldest inventory first and then the January and February inventory purchases. In other words, the 6,000 units comprised of (2,000 units for $32,000) + (2,000 units for $40,000 or Jan.) + (2,000 units for $50,000 or Feb.)
Beneath are the Ending Inventory Valuations:
• Ending Inventory per LIFO: 2,000 units x $16 = $32,000. Remember that the last units in (the recent ones) are sold first; thus, we leave the oldest units for ending inventory.
• Ending Inventory per FIFO: 2,000 units x $30 each = $60,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the recent units for ending inventory.
LIFO or FIFO: It does matter
The conflict between $32,000, $60,000 is substantial.
In a comprehensive essential analysis of Moonlight canning Company, we could use these inventory estimates to compute other metrics—factors that expose a firm's current financial health, and which allow us to make forecasts about its future, for instance.
So, which inventory figure a firm starts with when valuing its inventory does matter. And companies are required by law to state which accounting method they used in their published financials.
Although the Moonlight canning Company illustration above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO cost can be sophisticated.
Understanding how to manage inventory is an important instrument for businesses, small or large; as well as a crucial success factor for any business that holds inventory.
Managing inventory can help a company control and forecast its income. Conversely, not knowing how to use the inventory to its benefit, can avoid a company from operating efficiently.
For investors, inventory can be one of the most valuable items to analyze because it can contribute insight into what's happening with a company's core business.
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