FIFO vs LIFO Which Method Affects COGS More

If you work in accounting, the way you measure your inventory can have a big effect on your financial statements, especially the cost of goods sold (COGS). FIFO (First In, First Out) and LIFO (Last In, First Out) are two of the most popular ways to figure out how much an inventory is worth. Business owners need to know the differences between these methods because they can affect more than just financial reporting. They can also affect taxes and cash flow. This article will talk about FIFO vs. LIFO, and how to choose the best way for your business based on their effects on COGS.

What is FIFO?

When you use FIFO, or "First In, First Out," to figure out how much something is worth, the oldest things in the stock are sold first. In other words, when there is a sale, the cost of goods sold (COGS) is based on the oldest inventory. FIFO is often preferred in fields like food and medicine where material goes bad quickly or becomes outdated.

Advantages of FIFO

Reflects Current Costs: It takes into account current costs; FIFO is a better way to show how the market is doing right now because it uses the most recent prices for ending inventory.

Higher Profit Margins: When prices are going up, FIFO usually means lower COGS, which means higher reported earnings.

Simpler to Understand: FIFO is simple and follows the natural flow of inventory, which makes it easy for businesses to handle.

Disadvantages of FIFO

Higher Taxes: Because FIFO reports bigger profits, it can mean that you owe more in taxes.

Potential for Misleading Financials:When prices are going up, FIFO can make profits look better than they really are, which may not be a good reflection of cash flow.

What is LIFO?

Last In, First Out, or LIFO, is the opposite of First In, First Out. Using this method, the things that were just bought are sold first. This means that the prices of the newest items are used to figure out the cost of goods sold (COGS) after a sale. LIFO is often used in fields where the cost of goods is going up because it can help lower tax bills.

Advantages of LIFO

Tax Benefits: Because it matches the most recent (and often higher) costs to receipts, LIFO can lead to lower taxable income during times of inflation.

Better Matching of Costs and Revenues: LIFO can give a more accurate picture of present costs in the COGS calculation, especially when prices are going up.

Disadvantages of LIFO

Complexity: LIFO can be more complicated to manage and requires more detailed record-keeping.

Lower Profit Margins: When prices are going up, LIFO can cause COGS to go up, which means that reported earnings go down.

Not Accepted Under IFRS: LIFO is not permitted under International Financial Reporting Standards (IFRS), which can be a concern for businesses operating internationally.

How FIFO and LIFO Impact COGS

Choosing between FIFO and LIFO can have a big effect on cost of goods sold (COGS), which in turn has an effect on taxes and profit margins. This is how each method changes COGS:

FIFO and COGS

When prices are going up, FIFO will lead to lower COGS because the older, cheaper product costs are used first. This means that incomes go up and taxes might go up too.

When prices are going down, FIFO will make COGS go up because the older inventory costs more than the younger, cheaper inventory. This could mean less money in the bank.

LIFO and COGS

In a Rising Price Environment: LIFO will result in higher COGS because the newer, more expensive inventory costs are used first. This leads to lower profits and lower tax liabilities.

In a Falling Price Environment: LIFO will result in lower COGS, as the newer inventory costs are lower than the older inventory costs. This can lead to higher profits.

Common Questions About FIFO vs. LIFO

Which method is better for my business?

Whether you use FIFO or LIFO relies on your business, the type of inventory you have, and your financial goals. If you work with things that go bad quickly, FIFO might be better for you. On the other hand, LIFO might be better if you want to pay the least amount of taxes during inflation.

How do I choose the right method?

Consider the following when choosing between FIFO and LIFO:

• Market Conditions: Look at the present and expected market conditions, as well as inflation rates.

• Financial Goals: Decide whether you want to make more money or pay less in taxes.

• Industry Standards: Find out what methods are widely used in your field.

Can I switch between FIFO and LIFO?

Yes, companies can switch between FIFO and LIFO, but they need to plan ahead and follow financial rules. Talk to a financial expert or accountant before making any changes to make sure you're still following the rules.

Practical Tips for Managing Inventory Costs

Regular Inventory Audits: Conduct regular audits to ensure accurate inventory valuation and identify slow-moving items.

Use Accounting Software: Implement accounting software that supports both FIFO and LIFO methods to streamline your inventory management.

Monitor Market Trends: Stay informed about market trends that could impact your inventory costs and adjust your strategy accordingly.

Read More: Inventory vs Cost of Goods Sold

Read More: Calculating Cost of Goods Sold for Contractors - Expert Guide

Conclusion

Knowing the differences between FIFO and LIFO is important for business owners who want to keep track of their goods well and get the best COGS. There are pros and cons to each method, and the best one to use relies on your business's needs and the state of the market.

If it's too much for you to handle your inventory and accounts, you might want to work with Irvine Bookkeeping. Irvine Bookkeeping services can help you handle your money more efficiently, which will save you time and make sure you're getting everything right. We'll take care of the numbers while you work on building your business.