FIFO vs LIFO - Which is Better?
FIFO (First in First out) and LIFO (Last in First out) are two common methods that can be used for inventory valuation, the difference between them being how they account for cost of goods sold. Choosing the correct inventory valuation method is a crucial step for a business and can have a significant impact on reported profitability, so here we’ll take a look at the strengths and weaknesses for each approach, and finish up with why Brightpearl's inventory management software takes advantage of FIFO costing.
FIFO is where the cost of goods sold accounted for on a sale is the value of the oldest inventory. If your costs fluctuate, exercising FIFO can be more complex if you do not have a system in place to help keep track, but it does come with great advantages;
It’s realistic against what’s happening in the warehouse, given that most businesses ship older stock first to avoid it depreciating in value or spoiling
During inflation, FIFO increases the value of your inventory as you continue to purchase (as the inventory you’re buying next is more expensive), as well as net income, because your older items with a lower cost of goods would now be a smaller percentage of your sale price. The results being higher asset values and reported profitability, and that’s always nice!
- Your operational reports are more accurate - your balance sheet will reflect the actual costs that you paid to acquire inventory so you don’t have to apply any extra logic to find the exact amount paid to acquire your inventory.
LIFO accounts for your most recently received stock when you make a sale, even if you have other units that have been on the shelves for years and were purchased at a different price. With fluctuating costs, LIFO can be an easier approach initially but can have its issues as your business scales.
Keeps taxable income down when your cost prices rise (because you’ll be recording less profit)
If you plan to expand globally, not all country accounting standards allow a LIFO valuation (LIFO is permitted under GAAP and prohibited under IFRS)
- LIFO generally makes reporting hard - if you have high inventory turnover, with prices that rise and fall over time, then your stock valuation won’t represent the prices you actually paid - meaning your procurement and merchandising will never know exactly how much money you’ve already got held up in inventory.
Whilst LIFO has it’s place for those wishing to keep taxable income down, FIFO brings the most benefits to a growing retail or wholesale business. Higher reported profitability and asset values can help significantly in the search for investment. Many small businesses can be put off because of FIFO’s administrative overhead - tracking the full ins and outs of your inventory lines can get messy - but that’s where software can help!
Brightpearl and its merchants use FIFO - Brightpearl’s is a unique solution because we collate all purchasing, sales, and accounting activity under a single system, and can therefore accurately track everything for you - when you raise a purchase order for replenishment, your reports show the true value of your current inventory - when you receive the new inventory, we record its value as per the purchase invoice - when you make a sale, we record it’s cost as per FIFO - and when you want to look at your company's financials, you know it’s accurate and available in real time.