Inventory cost accounting using the FIFO method versus using the LIFO method.
The acronym FIFO stands for First In First Out.
The acronym LIFO stands for Last In First Out.
Both FIFO and LIFO are cost accounting fictions that can lead to very different numbers of
Cost Of Goods Sold and Gross Profit.
Let’s work through a visual as well as a numerical example of FIFO versus LIFO.
We will do the inventory accounting for a hypothetical company called Toy Giraffe Inc.
As the name suggests, this is a company buying and selling toy giraffes.
In the first quarter of the year, Toy Giraffe Inc is building up its inventory.
In January, they buy 100 units (packed in 2 boxes of 50 units each) at $5 per unit.
In February, 200 units (4 boxes of 50 units) at $6 per unit.
In March, another 100 units (2 boxes of 50 units) at $7 per unit.
The Q1 ending inventory is 400 units at a total purchase price of $2400, so on average
$6 per unit.
In the warehouse, the company does not specifically identify the boxes, they just stack them on
a big pile.
For cost accounting and inventory valuation purposes, the company does keep track of the
timing of the buys and the unit cost.
Then we go to April.
The ending inventory of Q1 is the beginning inventory of Q2.
The visual representation of the FIFO inventory flow is at the top, LIFO is at the bottom.
The first box of toy giraffes (50 units) is sold in April.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first: one
of the boxes purchased in January.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first: one
of the boxes purchased in March.
Two boxes of toy giraffes are sold in May.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first: the
last of the boxes purchased in January, and one of the boxes bought in February.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first: the
last of the boxes purchased in March, and one of the boxes bought in February.
Four boxes of toy giraffes are sold in June.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first: the
remaining three boxes bought in February, and one box purchased in March.
What stays in inventory at quarter end under FIFO, is one box purchased in March.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first: the
remaining three boxes bought in February, and one box purchased in January.
What stays in inventory at quarter end under LIFO, is one box purchased in January.
Let’s compare FIFO and LIFO numerically.
For both FIFO and LIFO, the number of units in inventory at both the start and the end
of April is the same.
The ending inventory is 7 boxes of 50 units each, 350 units in total.
For inventory valuation as well as determining Cost Of Goods Sold, it is important to determine
what is the cost per unit for this specific box.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first, so we
assume that the box sold originated from the January buy.
What remains in inventory at the end of April is 50 units from the January buy, the full
200 units from the February buy, and the full 100 units from the March buy.
In total, 350 units with a total purchase price of $2150, so on average $6.14 per unit,
an increase of the weighted average unit cost up from $6 previously.
If we prepare the income statement for April, revenue is 50 units times $10 = $500, Cost
Of Goods Sold (or COGS) is 50 units times $5 = $250, and Gross Profit is $250.
Out of the January buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first, so we
assume that the box sold originated from the March buy.
What remains in inventory at the end of April is the full 100 units from the January buy,
the full 200 units from the February buy,
and the remaining 50 units from the March buy.
In total, 350 units with a total purchase price of $2050, so on average $5.86 per unit.
Under LIFO, the average cost per unit in inventory goes down in this example, compared to the
$6 previously.
If we prepare the income statement for April, revenue is 50 units times $10 = $500, Cost
Of Goods Sold (or COGS) is 50 units times $7 = $350, and Gross Profit is $150.
Out of the March buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
Onward to May.
The ending inventory is 5 boxes of 50 units each, 250 units in total.
Applying FIFO, what remains in inventory at the end of May is zero units from the January
buy, 150 units from the February buy, and the full 100 units from the March buy.
In total, 250 units with a total purchase price of $1600, so on average $6.40 per unit.
If we prepare the income statement for May, revenue is 100 units times $10 = $1000, Cost
Of Goods Sold (or COGS) is 50 units times $5 = $250 plus 50 units times $6 = $300, and
Gross Profit is $450.
Out of the remaining January buy that was part of the beginning inventory, we took all
50 units to COGS, and we took 50 units from the February buy into COGS.
The remaining 150 units from the February buy go to the ending inventory.
Applying LIFO, what remains in inventory at the end of May is the full 100 units from
the January buy, 150 units from the February buy, and no units from the March buy.
In total, 250 units with a total purchase price of $1400, so on average $5.60 per unit.
If we prepare the income statement for May, revenue is 100 units times $10 = $1000, Cost
Of Goods Sold (or COGS) is 50 units times $7 = $350 plus 50 units times $6 = $300, and
Gross Profit is $350.
Out of the remaining March buy that was part of the beginning inventory, we took all 50
units to COGS, and we took 50 units from the February buy into COGS.
The remaining 150 units from the February buy go to the ending inventory.
Onward to June.
The ending inventory is just 1 box of 50 units.
Applying FIFO, what remains in inventory at the end of June is just 50 units from the
March buy: 50 units of $7 each, $350 in total.
If we prepare the income statement for June, revenue is 200 units times $10 = $2000, Cost
Of Goods Sold (or COGS) is 150 units times $6 = $900, plus 50 units times $7 = $350,
so total COGS of $1250, and therefore a Gross Profit of $750.
Out of the remaining February buy that was part of the beginning inventory, we took all
150 units to COGS, and we took 50 units from the March buy into COGS.
The remaining 50 units from the March buy go to the ending inventory.
Applying LIFO, what remains in inventory at the end of June is just 50 units from the
January buy: 50 units of $5 each, $250 in total.
If we prepare the income statement for June, revenue is 200 units times $10 = $2000, Cost
Of Goods Sold (or COGS) is 150 units times $6 = $900, plus 50 units times $5 = $250,
so total COGS of $1150, and therefore a Gross Profit of $850.
Out of the remaining February buy that was part of the beginning inventory, we took all
150 units to COGS, and we took 50 units from the January buy into COGS.
The remaining 50 units from the January buy go to the ending inventory.
To summarize FIFO versus LIFO, here are the Cost Of Goods Sold and ending inventory values
by period.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first.
In both the FIFO and the LIFO method, no COGS in Q1 as we did not sell anything.
FIFO Cost Of Goods Sold: $250 in April, $550 in May, $1250 in June, $2050 for all of Q2.
The ending inventory value is simply the previous period’s inventory value
minus this month’s COGS.
Start with $2400 at the end of Q1, then $2150 end of April, $1600 end of May,
$350 for end of June.
When using LIFO, the pattern over the months as well as the ending values are different.
$350 COGS in April, $650 in May, $1150 in June, $2150 for all of Q2.
The ending inventory value is simply the previous period’s inventory value
minus this month’s COGS.
Start with $2400 at the end of Q1, then $2050 end of April, $1400 end of May,
$250 for end of June.
With FIFO, in the earlier periods (April and May) of this example, the Cost Of Goods Sold
is lower and therefore both the inventory value and the Gross Profit are higher, than
when applying LIFO.
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