If Prices Continue to Increase Would You Favor Adopting the Fifo or the Lifo Method

FIFO vs LIFO and its Effect on Gross Profit

FIFO and LIFO are different inventory costing methods. Consequently the method chosen (FIFO vs LIFO) will affect the valuation placed on the ending inventory and the value of cost of goods sold (COGS).

Given these points the difference between the FIFO and LIFO methods is summarized in the diagrams below which show the sale of two units. The number inside each unit represents its cost price.

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FIFO vs LIFO Example

By way of illustration, the following example explains the different outcomes when considering FIFO vs LIFO.

If a business had the following inventory information for August:

• August 1 Beginning inventory 100 units @ 3.00 cost per unit
• August 4 Purchased 400 units @ 2.50 cost per unit
• August 24 Purchased 300 units @ 6.00 cost per unit
• August 31 Sold 200 units

In this situation if the units were sold for 10.00 each, calculate the gross profit.

FIFO Method

Firstly to compare FIFO vs LIFO we take a look at the FIFO method. In this case using FIFO the first items into inventory are the first items to be sold.

FIFO Method Showing Units

Unit Cost	3.00	2.50	6.00	Total
Beginning	100			100
Purchase		400	300	700
Sell	– 100	– 100		– 200
Ending	0	300	300	600

This table converts the units in the table above to cost at either 3.00, 2.50 or 6.00 per unit.

FIFO Method Showing Cost

Unit Cost	3.00	2.50	6.00	Total
Beginning	300			300
Purchase		1,000	1,800	2,800
Sell	– 300	– 250		– 550
Ending	0	750	1,800	2,550

In this case using FIFO, the ending inventory is valued at 2,550 and cost of goods sold is 550. If the units sell for 10.00 each then the gross profit is calculated as follows:

Gross profit = Revenue - COGS Gross profit = 200 x 10.00 - 550  Gross profit = 1,450        

LIFO Method

Finally the second method in our FIFO vs LIFO comparison is LIFO. In the LIFO method the last items into inventory are the first items to be sold.

Using the same values with the LIFO method we get the following result:

LIFO Method Showing Units

Unit Cost	3.00	2.50	6.00	Total
Beginning	100			100
Purchase		400	300	700
Sell			– 200	– 200
Ending	100	400	100	600

This table converts the units in the table above to values at either 3.00, 2.50  or 6.00 per unit.

LIFO Method Showing Value

Unit Cost	3.00	2.50	6.00	Total
Beginning	300			300
Purchase		1,000	1,800	2,800
Sell			– 1,200	– 1,200
Ending	300	1,000	600	1,900

In this case using LIFO, the ending inventory is valued at 1,900 and cost of goods sold is 1,200.

If the units sell for 10.00 each then the gross profit is calculated as follows:

Gross profit = Revenue - COGS Gross profit = 200 x 10.00 - 1,200 Gross profit = 800        

FIFO vs LIFO Comparison of Gross Profit

The FIFO versus LIFO comparison shows that the gross profit using LIFO (800) is lower than the gross profit using FIFO (1,450). To illustrate this is summarized in the table below.

Comparison of FIFO vs LIFO Gross Profit

	FIFO	LIFO
Revenue	2,000	2,000
COGS	550	1,200
Gross profit	1,450	800

The cost of goods sold in LIFO is normally higher than in FIFO as it is valued using the last items into inventory which, in times of inflation and rising prices, tend to be the highest valued items.

FIFO vs LIFO Comparison Cost Allocation

Note that the cost of goods sold plus the ending inventory is the same in each case. It's only the split between the two items which changes.

Comparison of FIFO vs LIFO Cost Allocation

	FIFO	LIFO
Ending	2,550	1,900
COGS	550	1,200
Total	3,100	3,100

FIFO vs LIFO Comparison – Rising and Falling Prices

To conclude the effect of rising and falling prices on gross profit, cost of goods sold and ending inventory of using FIFO or LIFO is summarized in the tables below.

In each case the table shows the method which gives the highest value, for example in times of rising prices FIFO will give the highest gross profit.

Method giving highest value

Prices	Inventory	COGS	Profit
Rising	FIFO	LIFO	FIFO
Falling	LIFO	FIFO	LIFO

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

October 21, 2022

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Source: https://www.double-entry-bookkeeping.com/inventory/fifo-vs-lifo/

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