FIFO-LIFO in Operational Management

Summary

This video explores two key inventory management methods—FIFO (First In, First Out) and LIFO (Last In, First Out)—detailing how they impact a company's financial outcomes. FIFO sells older inventory first, leading to lower cost of goods sold during inflation and higher net income. LIFO sells newer inventory first, reducing tax liabilities by reporting higher costs during inflation but often results in lower net income. The video compares these methods' effects on cost of goods sold, net income, taxes, and ending inventory, highlighting their advantages, disadvantages, and applications in different industries and economic conditions.

Takeaways

• 😀 FIFO (First In, First Out) assumes that the first items purchased or produced are the first to be sold, affecting both cost of goods sold (COGS) and ending inventory.
• 😀 LIFO (Last In, First Out) assumes that the last items purchased or produced are the first to be sold, which impacts COGS and ending inventory differently compared to FIFO.
• 😀 Inventory valuation directly affects cost of goods sold (COGS), gross profit, and net income, all of which play a significant role in financial reporting and tax liabilities.
• 😀 FIFO tends to result in a lower COGS during inflation, leading to higher profits and higher taxes due to the sale of older, cheaper inventory.
• 😀 LIFO, on the other hand, results in higher COGS during inflation, leading to lower profits and tax savings due to the sale of more recent, expensive inventory.
• 😀 The FIFO method reflects the physical flow of goods more accurately, especially in industries like food and retail, where older products are sold first.
• 😀 LIFO is not permitted under International Financial Reporting Standards (IFRS), limiting its use to countries like the U.S. that allow it under GAAP.
• 😀 FIFO's ending inventory is valued at the most recent prices, providing a better reflection of the current market value of inventory.
• 😀 LIFO can undervalue ending inventory as it uses older, lower-cost items, especially during inflationary periods.
• 😀 FIFO is ideal for businesses that sell goods in the order they were purchased, such as in retail, food, and pharmaceuticals, while LIFO is suitable for industries where inventory costs are rising rapidly, like oil or commodities.
• 😀 In times of rising prices, FIFO typically results in higher net income, while LIFO can reduce net income but provide tax advantages due to higher COGS.

Q & A

What is the primary purpose of inventory management in businesses?

Inventory management is crucial for business operations as it impacts profitability, tax liabilities, and financial reporting. It helps businesses track the costs of goods sold (COGS) and the value of ending inventory.

What are the two main inventory valuation methods discussed in the script?

The two main inventory valuation methods are FIFO (First In, First Out) and LIFO (Last In, First Out). These methods are used to calculate the cost of goods sold and the value of ending inventory.

How does the FIFO method work?

FIFO assumes that the first goods purchased or produced are the first to be sold. As a result, the cost of goods sold is based on the older inventory, and the ending inventory is valued at the most recent purchase prices.

What is an example of how FIFO is calculated?

For example, if a company purchased 100 units at $10 each, 200 units at $12 each, and 150 units at $14 each, and sells 250 units, the first 100 units sold would be at $10 each, followed by 50 units at $12 each. This gives a total COGS of $2,800.

What are the advantages of using the FIFO method?

The advantages of FIFO include higher net income during inflationary periods, as older inventory (cheaper) is sold first, leading to lower COGS and higher profits. It also reflects the physical flow of goods more accurately in industries like food and retail.

What are the disadvantages of FIFO?

The main disadvantage of FIFO is that it results in higher taxes during inflation because of the higher net income. It also does not match current costs with current revenues, as older inventory costs may not reflect the true cost of replacing goods.

How does the LIFO method work?

LIFO assumes that the last goods purchased or produced are the first to be sold. Therefore, the cost of goods sold is based on the newer inventory, while the ending inventory consists of older goods.

What is an example of how LIFO is calculated?

Using the same inventory data, if the company sells 250 units, the first 150 units sold would be at $14 each, followed by 100 units at $12 each. This results in a total COGS of $3,300.

What are the advantages of using the LIFO method?

LIFO provides a tax advantage in inflationary periods by reporting higher COGS, which reduces net income and taxes. It also better matches current costs with current revenues, reflecting the actual cost of replacing inventory.

What are the disadvantages of LIFO?

LIFO has several disadvantages, including lower net income due to higher COGS, which may make a company appear less profitable. It also results in unrealistic inventory values, as the ending inventory is valued at older, lower costs. Additionally, LIFO is not allowed under international financial reporting standards (IFRS).

How do FIFO and LIFO affect financial reporting and taxes?

FIFO tends to result in higher net income and higher taxes during inflation, as older inventory is sold first. LIFO results in lower net income and lower taxes, as newer inventory is sold first. The choice between FIFO and LIFO can significantly impact a company's tax liabilities and overall financial performance.

Which industries are more suitable for FIFO or LIFO?

FIFO is ideal for industries where inventory needs to be sold in the order it was purchased, such as in retail, food, and pharmaceuticals. LIFO is better suited for industries with rapidly rising inventory costs, such as oil or commodities, where businesses aim to minimize taxes.

How does inflation impact the choice between FIFO and LIFO?

During inflationary periods, FIFO results in a lower COGS and higher net income, but also leads to higher taxes. In contrast, LIFO results in a higher COGS and lower net income, which can help reduce tax liabilities by conserving cash.

Is LIFO allowed internationally?

LIFO is not allowed under International Financial Reporting Standards (IFRS), limiting its use to countries like the United States that permit it under Generally Accepted Accounting Principles (GAAP).