The acronyms LIFO (last in, first out) and FIFO (first in, first out) are inventory management terms that help companies to keep track of inventory costs and profit generated. Most companies calculate both and use each number based on the company’s accepted accounting practices.
Inventory that is “first in, first out” means that the older inventory was sold first. It is the same idea as cars in line at a restaurant drive-through window. The cars that are in line first are the cars that will get served and sent on their way first.
When product is “last in, first out,” it means that the freshest product sells first. As an example, a bag of potato chips is filled from the bottom to the top. The chips that were last in will sit on top and they will be the first to be eaten.
As an example, let us say that a company bought 100 units of a product in June at $1.00 each, 200 units of a product in July at $1.50 each and 300 units of a product in August at $2.00 each. In September, 400 units are sold. Using the FIFO method, that means that all 100 June units sold, all 200 of the July units sold and 100 of the August units sold. The formula would look like this:
FIFO = ((100 x 1.00) + (200 x 1.5) + (100 x 2.00)) / 400
The FIFO price is $1.50 per unit.
Using the same example, we would have sold all 300 of the August units at $2.00 each and 100 of the July units at $1.50 each. The formula would look like this:
LIFO = ((300 x 2.00) + (100 x 1.50)) / 400
The LIFO price is $1.88 per unit.
When Are LIFO And FIFO Used
These two inventory valuation methods are used to put a value on inventory when a company files its taxes, tries to determine cash flow and tries to determine is cash status at any given time. There is no rule on which should be used, but each have their own effect on the bottom line.
The FIFO method generally results in more income for the company because it utilizes older inventory which is generally less costly. The LIFO method results in less income because it tends to use newer and more expensive inventory.
The average cost of inventory is another valuation method that would fall somewhere between LIFO and FIFO. Companies use these methods depending on their needs. If a company needs to bring down the earnings per share for a quarter, then it would use the LIFO method.
It is extremely dangerous for companies to jump back and forth between LIFO and FIFO because it will anger investors and pique the interest of the IRS. Most companies choose one method and stick with it. When investors are considering where to put their money, the inventory valuation method each company uses can have a significant effect on their decision.