FIFO and LIFO

Inventory is the key item that appears in most types of Balance Sheets. For a company that manufactures or sells physical goods, inventory includes everything that goes into those products, such as raw materials, work-in-progress and finished goods.

Costs Included in Inventory Valuation are:

Direct labor: Includes wages paid to those involved in assembling the products, the payroll taxes, pension contributions and any company-paid insurance coverage for these employees.

Direct materials: Any materials and supplies used in manufacturing a product count as direct materials. This includes supplies that are consumed or discarded in the process, as well as any materials that are damaged and unusable. A good rule of thumb is any cost that varies with each unit of manufacture is a direct cost.

Factory overhead: Factory overhead covers all expenses incurred during the manufacturing process other than direct labor and direct materials. Examples include the salaries of people who are involved in producing inventory but not actually making the products, such as production supervisors, quality assurance professionals and materials managers. Factory overhead also includes rent, utilities, insurance, equipment setup and maintenance costs. It also includes the purchase cost of small factory tools that are fully expensed when acquired, as well as the depreciation costs of larger equipment.

Freight in: This is the transportation cost for the delivery of goods to the company. There is a matching freight-out cost if a company offers free or discounted shipping to its customers and absorbs the associated costs.

Handling: This includes everything involved in preparing a finished product for shipping: the labor involved in picking the inventory, packing it for shipment, generating a shipping label and getting the product onto a truck.

The overall objective of inventory valuation is to help create an accurate picture of a company’s gross profitability and financial position. To calculate the gross profit listed on the company’s income statement, a company must subtract the cost of goods sold (COGS) from net sales.

The basic formula for COGS at the end of any accounting period is:

COGS = Beginning inventory + Purchases – Ending inventory

As a note, COGS includes the direct cost of materials and labor required to create the good and doesn’t include indirect expenses such as marketing and distribution.

Inventory Valuation Methods

Inventory valuation is the accounting process of assigning value to a company’s inventory.

The method a company uses to value its inventory directly affects its gross profit and income statement.

Companies generally have a choice of four different inventory valuation methods, each with its pros and cons. It’s important they consider all the potential advantages and disadvantages of each approach and choose carefully:

• First In, First Out (FIFO). This is the most intuitive and widely used method. It assumes that the first product a business sells is from the first (or oldest) set of materials or goods it bought and values the inventory accordingly.

First-in goods are generally cheaper than those that follow because materials prices and other inventory costs tend to rise over time due to inflation. FIFO therefore generally results in a lower COGS and higher gross income than other valuation methods.

FIFO method most closely matches the actual inventory costs, but it has two significant disadvantages. First, a higher gross income translates to a bigger tax bill. Second, during periods of high inflation, FIFO can result in financial statements that can mislead investors.

• Last In, First Out (LIFO). This model assumes that the newest inventory is sold first.

LIFO provides a more precise matching of expenses with revenue. It also raises COGS and lowers the company’s tax bill. But it often presents an out-of-date number on the balance sheet and can keep the cost of goods bought earlier in the inventory account for many years.

• Weighted average cost (WAC). As the name suggests, WAC uses an average of all inventory costs. WAC is generally used when inventory items are identical. It can simplify inventory costing because it avoids the need to track the cost of separate inventory purchases when calculating profit and tax liability. The other advantage of WAC is that it reduces fluctuations in profit due to the timing of purchases and sales. Its most obvious disadvantage is that a WAC system is not sophisticated enough to track FIFO or LIFO inventories.

• FIFO tends to produce the highest gross income during the current period, LIFO the lowest, and WAC something in between. This assumes a typical inflationary environment in which the cost of supplies generally rises over time. Consequently, FIFO generates the highest taxes and LIFO the lowest, with WAC again in the middle.
• LIFO is allowed under U.S. Generally Accepted Accounting Principles (GAAP) but not under International Financial Reporting Standards (IFRS). So LIFO can currently be used in the U.S. but not in many other countries.

Example:

FIFO COGS = C21*C11+C20*C9

LIFO COGS = C21*C17+C20*C15

In the LIFO outcome, the cost of inventory is higher, which results in lower profits but less taxable income.