There is more to inventory valuation than simply entering the amount you pay for your inventory into your accounting software. There are a number of ways you can value your inventory, and choosing the best inventory valuation method for your business depends on a variety of factors.
FIFO and LIFO are the two most common inventory valuation methods. FIFO stands for “first in, first out” and assumes the first items entered into your inventory are the first ones you sell. LIFO, also known as “last in, first out,” assumes the most recent items entered into your inventory will be the ones to sell first. The inventory valuation method you choose will depend on your tax situation, inventory flow and recordkeeping requirements.
Inventory valuation methods
There are five ways in which a business can choose to calculate the cost or value of inventory:
Specific identification: Specific identification inventory valuation attaches cost to specific items in inventory. This is done using serial numbers or some other unique identifier.
Weighted average: The weighted-average method of inventory valuation is often used when inventory is not perishable but stock can still easily be rotated or intermingled.
Retail method: Instead of valuing inventory based on the cost to acquire the inventory, the retail method values inventory based on the retail price of the inventory, reduced by the markup percentage. This is the least specific inventory valuation method.
First in, first out (FIFO): The FIFO method of inventory valuation assumes the first items entered into your inventory are the first items you sell. FIFO inventory valuation assumes any inventory left on hand at the end of the accounting period should be valued at the most recent purchase price. Anything purchased at an older price would have been discarded due to spoilage or other loss of value.
Last in, first out (LIFO): LIFO inventory valuation is essentially the opposite of FIFO inventory costing. The LIFO method assumes the most recent items entered into your inventory will be the ones to sell first.
What to consider
There is no wrong method to use to value your inventory, but there is a best way for your business. The method you choose depends on four different factors:
Inventory flow: Most businesses sell the oldest items in stock first. Think of a grocery store or a clothing boutique: In both of these types of businesses, stock loses its value with time, and so the older items are pushed to the front of the shelves to help them sell quicker. There are some instances, though, when the newer inventory is sold first. A lumberyard is a good example. Wood, concrete and gravel aren’t rotated as new stock arrives, and so the newer inventory would be sold before the older inventory.
Inflation or deflation: In periods of inflation — when costs and prices are on the rise — your older inventory costs less than your newer inventory. And chances are, you will raise your prices before your old inventory is depleted. This increases your gross profit margin… and your taxable income. Similarly, in periods of deflation, your older inventory costs less than your newer inventory. Your prices are also likely to come down before your old inventory is depleted, so you show less profit on your financial statements.
Recordkeeping: When comparing FIFO vs. LIFO, the recordkeeping requirements for LIFO are typically more onerous than those for FIFO. This is because the inventory in a business that uses LIFO is “layered,” meaning older inventory can be held for long periods of time. A business that uses FIFO assumes the older stock is rotated quickly and regularly.
Financial reporting requirements: LIFO inventory valuation is allowed by the IRS and under generally accepted accounting principles (GAAP). It is not, however, allowed under international financial reporting standards (IFRS).
Let’s say you own a craft supply store specializing in materials for beading. Your inventory doesn’t expire before it’s sold, and so you could use either the FIFO or LIFO method of inventory valuation.
Over the course of the past six months, you have purchased spools of wire.
You have purchased a total of 140 spools of wire during this period. You conduct a physical inventory and determine you have sold 120 spools of wire during this same period.
Regardless of the price you paid for your wire, you chose to keep your selling price stable at $7 per spool of wire.
FIFO inventory valuation
Since you kept your price stable at $7 per spool of wire, you know your gross revenue was $840 ($7 x 120 spools). But what is your profit?
If you use the FIFO method of inventory valuation, you assume your oldest spools of wire were sold first. This means your costs are as follows:
Since you purchased 140 spools and sold 120, this table doesn’t include the 20 spools you purchased in June at $5 per spool, since these were the last in. Per the FIFO method, the first spools you purchased were the first out, meaning the last spools you purchased in June still remain in your inventory.
Your profit over the past six months is calculated as follows:
Gross Revenue – Cost of Goods = Gross Profit
$840 – $340 = $500
Your profit for the wire is $500.
LIFO inventory valuation
Now let’s see what your profit is if you use the LIFO inventory valuation method. Your gross revenue is still $840, but how will your profit change by choosing a different valuation method?
Your profit over the past six months is calculated by the LIFO method as follows:
Gross Revenue – Cost of Goods = Gross Profit
$840 – $380 = $460
Your profit for the wire is $460—$40 less than under the FIFO method.
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What it means for your bottom line
A $40 profit differential wouldn’t make a significant difference to your bottom line. For the sake of simplicity, we kept the numbers in the example small. Also, we only looked at one item in your entire inventory. But you can easily see that — if the dollar amounts or the quantities sold were higher, and you factor in the different products in your craft store — choosing LIFO over FIFO would have a significant impact on your business’s profitability.
Of course, you want your business to be profitable. However, you also don’t want to pay more in taxes than is absolutely necessary. You neither want to understate nor overstate your business’s profitability. This is why choosing the inventory valuation method that is best for your business is critically important.
Inventory valuation for tax purposes
The IRS knows business owners want to minimize their tax burden. In order to keep taxpayers from gaming the system by valuing their inventory on a FIFO basis one year and LIFO the next, there are rules in place regarding inventory valuation:
If you want to use LIFO inventory valuation, you must file Form 970 with the IRS. You can choose to value all your inventory using LIFO, or you can use LIFO just for certain goods you carry.
Once you elect to use LIFO for your inventory valuation, you cannot switch back to FIFO or another inventory valuation method without express permission from the IRS. To request a change in inventory valuation from the IRS, you must complete Schedule D, Part 2 of Form 3115.
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Beyond tax impact
Tax impact isn’t the only consideration when choosing your inventory valuation method. As mentioned earlier, inventory flow, recordkeeping and reporting requirements also play a role in your inventory valuation method. When deciding whether FIFO vs. LIFO is right for your business, consider these factors as well:
For spools of craft wire, you can reasonably use either LIFO or FIFO valuation. For perishable goods — like groceries — or other items that lose their value with time, using LIFO valuation doesn’t make sense because you will always try to sell older inventory first.
If you choose to use the LIFO method of inventory valuation, you will need a recordkeeping system that allows you to determine when you access older “layers” of inventory and then apply the cost of that older inventory accurately. Many businesses find this requirement alone negates any benefits of LIFO valuation.
If you are looking to do business internationally, you must keep IFRS requirements in mind. LIFO valuation is not allowed under these standards. If you plan to do business outside of the U.S., choose FIFO or another inventory valuation method instead.
Which is right for you?
There are a number of factors that impact which inventory valuation method you should use. Tax considerations play a large role in your choice, but tax impact shouldn’t be the only thing you consider when choosing between FIFO and LIFO.
Although FIFO is the most common and trusted method of inventory valuation, don’t default to using FIFO. In certain cases, LIFO might be the better choice. Discuss your inventory valuation options with your accountant. He or she will be able to help you make the best inventory valuation method decision for your business based on your tax situation, inventory flow and recordkeeping requirements.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.
When choosing an inventory valuation method, consider a few elements. First, you should identify the cash flow implications and evaluate what cash flow might look like in the next three to five years. Second, consider the impacts on your financial statements. Will you benefit most from having higher net income?Is the FIFO method the most accurate method for inventory valuation? ›
The obvious advantage of FIFO is that it's the most widely used method of valuing inventory globally. It is also the most accurate method of aligning the expected cost flow with the actual flow of goods which offers businesses a truer picture of inventory costs.Which is the better method FIFO or LIFO Why? ›
FIFO is more likely to give accurate results. This is because calculating profit from stock is more straightforward, meaning your financial statements are easy to update, as well as saving both time and money. It also means that old stock does not get re-counted or left for so long it becomes unusable.Why would a company choose FIFO over LIFO? ›
Most companies prefer FIFO to LIFO because there is no valid reason for using recent inventory first, while leaving older inventory to become outdated. This is particularly true if you're selling perishable items or items that can quickly become obsolete.Which inventory method is best? ›
The FIFO method is the most popular inventory method because it's the one that most closely matches the actual movement of inventory for most businesses. This method assumes that the first products you acquired will be the first that are sold.Which valuation method is the most accurate? ›
Discounted Cash Flow Analysis (DCF)
In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise.
For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.What is the best approach for inventory accuracy? ›
- Make sure your warehouse is organized at all times.
- Have good inventory naming and labeling practices.
- Create and follow documented policies and procedures.
- Utilize cycle counting as a more efficient way to count inventory.
First-In, First-Out (FIFO)
The oldest inventory products are sold first as per the FIFO method. The FIFO valuation method is the most commonly used inventory valuation method as most of the companies sell their products in the same order in which they purchase it.
Less waste (a company truly following the FIFO method will always be moving out the oldest inventory first). Remaining products in inventory will be a better reflection of market value (this is because products not sold have been built more recently). Higher profit. Financial statements are harder to manipulate.
The four main inventory valuation methods are FIFO or First-In, First-Out; LIFO or Last-In, First-Out; Specific Identification; and Weighted Average Cost.Why would a company switch to the LIFO method of inventory valuation? ›
LIFO can be beneficial since the most recent higher-priced items will be considered sold and removed, leaving the lower-cost items as your ending inventory. This means a higher Cost of Goods Sold, which reduces your business's taxable income.Why is LIFO more accurate? ›
Compliance with the matching principle – Unlike FIFO, LIFO complies with the matching principle, because the revenues and costs are recorded in the same period. As a result, both revenue and costs are recorded with the most recent values.Why is LIFO not accepted? ›
IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete.What are the 3 most commonly used methods for valuation of inventory? ›
What are the different inventory valuation methods? There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and WAC (Weighted Average Cost).What is the most widely used method of inventory control? ›
The Economic Order Quantity inventory management method is one of the oldest and most popular. EOQ lets you know the number of inventory units you should order to reduce costs based on your company holding costs, ordering costs, and rate of demand.Why is it important to choose the best valuation method? ›
Choosing the right method to value your business will play a significant role in the return on your investment when you exit. One of the biggest errors business owners can make when approaching a company valuation is not seeking professional guidance.What valuation method does Warren Buffett use? ›
Buffett follows the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. There isn't a universally accepted way to determine intrinsic worth, but it's most often estimated by analyzing a company's fundamentals.What is the most important factor in valuation? ›
Purpose: The Most Important Business Valuation Factor
In the factors that lead to a valuation of the company's worth, the purpose of the valuation is the most important.
Inventory accuracy can reach approximately 99.9% when inventory is tracked using barcodes and RF handheld inventory functions. Inventory accuracy is ensured by scanning and validating locations and product barcodes.
The first-in, first-out (FIFO) accounting method has two key disadvantages. It tends to overstate gross margin, particularly during periods of high inflation, which creates misleading financial statements. Costs seem lower than they actually are, and gains seem higher than they actually are.Why do companies choose FIFO? ›
If your inventory costs are going down as time goes on, FIFO will allow you to claim a higher average cost-per-piece on newer inventory, which can help you save money on your taxes. Additionally, FIFO does not require as much recordkeeping as LIFO, because it assumes that older items are gone.Why does Apple use FIFO method? ›
Adopting FIFO enables Apple to considerably reduce the aggregation of its old products in inventory. Financial Impact: Apple uses the serialized stock technique which creates space for maximizing the proficiency of the goods that will follow in line. This also helps the brand introduce new stock consistently.What are the pros and cons of FIFO? ›
|COMPLEXITY||Less complex. Minimal to no COGS fluctuation.|
|INFLATION||Lower COGS. Higher profits. Greater tax liability. Higher earnings and net worth appeal to investors.|
|DEFLATION||Higher COGS. Lower profits. Reduced tax liability. Lower earnings and net worth may discourage investors.|
During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO, firms can save on taxes as well as better match their revenue to their latest costs when prices are rising. International Financial Reporting Standards (IFRS).When would you use the LIFO method? ›
The LIFO method is used in the COGS (Cost of Goods Sold) calculation when the costs of producing a product or acquiring inventory has been increasing. This may be due to inflation.Why should we follow the FIFO first in first out? ›
FIFO helps food establishments cycle through their stock, keeping food fresher. This constant rotation helps prevent mold and pathogen growth. When employees monitor the time food spends in storage, they improve the safety and freshness of food. FIFO can help restaurants track how quickly their food stock is used.Can you switch between LIFO and FIFO for stock sales? ›
Yes, you can choose which stocks you sell by giving the proper instructions to your stock broker. The IRS does not prohibit you from choosing the LIFO (last in, first out) method rather than the FIFO method.What factors affect your decision to use LIFO FIFO or average cost method? ›
Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.Why would a company choose LIFO? ›
Pros of LIFO
A higher cost of goods sold, lower profits, less tax liability with inflation. During deflation, lower cost of goods sold, higher profits, and higher tax liability. More profits and more appealing to investors during deflation.
FIFO (“First-In, First-Out”) assumes that the oldest products in a company's inventory have been sold first and goes by those production costs. The LIFO (“Last-In, First-Out”) method assumes that the most recent products in a company's inventory have been sold first and uses those costs instead.Can a company use both LIFO and FIFO? ›
The U.S. accounting standards organization, the Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting.Which one should be used first when following FIFO? ›
FIFO is “first in first out” and simply means you need to label your food with the dates you store them, and put the older foods in front or on top so that you use them first. This system allows you to find your food quicker and use them more efficiently.Why LIFO is not allowed? ›
IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete.Is LIFO or FIFO better when prices are rising? ›
When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income.What happens when you switch from FIFO to LIFO? ›
FIFO moves the first/oldest costs from inventory and reports them as the cost of goods sold and leaves the last/more recent costs in inventory. LIFO moves the latest/more recent costs from inventory and reports them as the cost of goods sold and leaves the first/oldest costs in inventory.What is the best cost basis method to use? ›
Choosing the best cost basis method depends on your specific financial situation and needs. If you have modest holdings and don't want to keep close track of when you bought and sold shares, using the average cost method with mutual fund sales and the FIFO method for your other investments is probably fine.What is the risk of using LIFO method of inventory valuation? ›
Disadvantages of Using LIFO in Your Warehouse
LIFO is more difficult to maintain than FIFO because it can result in older inventory never being shipped or sold. LIFO also results in more complex records and accounting practices because the unsold inventory costs do not leave the accounting system.