In keeping with our attempt to provide Small Business Owners and Self-Employed Individuals with the information they need to manage their business' finances during these troubled times, today we'll be discussing different methods of valuing your inventory. Specifically, we'll be discussing FIFO and LIFO and why you might choose one over the other. But first we'll need to explain why you’ll even need to pick a method to use.
To keep it simple, when you purchase goods to sell the cost of each unit influences the total value of your Inventory asset. When you sell items, the Inventory will decrease and the Cost of Goods Sold (COGS) will be determined by method you've chosen: FIFO or LIFO.
If you've chosen the First-In First-Out (FIFO) method, then the first units that you purchase are considered the first ones that will be sold. It is the most commonly used method as it best follows the flow of physical goods and moves the oldest inventory first.
If you've chosen the Last-In First-Out (LIFO) method, then the last units that you purchase are considered the first ones that will be sold. It is less often used than FIFO due to a number of reasons that will be discussed later.
In general, when cost of goods are rising, FIFO has a tendency to provide higher gross profits due to the older goods costing less than recent ones. When cost of goods are falling, LIFO has a tendency to provide higher gross profits due to the newer goods costing less than older ones. To demonstrate, we'll use the following information in an example:
· On May 1st you purchase 10 T-Shirts for $5 each.
· On May 5th you purchase 5 T-Shirts for $12 each.
· On May 10th you sold 13 T-Shirts at $15 each for a total of $195.
Under FIFO, the first ten T-Shirts will be from the set that cost $5 each. The remaining three will come from the set that are $12. These totals bring your COGS up to $86 and will leave your total Revenue at $109.
Under LIFO, the first five T-Shirts will be from the set that cost $12 each. The remaining eight will come from the set that are $5. These totals bring your COGS up to $100 and will leave your total Revenue at $95.
Because the cost increased between the unit purchases, FIFO will show a higher profit than LIFO in this instance.
It should be noted that there are a lot of disadvantages to using LIFO. The United States is the only country that allows LIFO, it isn’t practical for perishable products, and even non-perishable ones can run the risk of becoming obsolete. It is usually better to stick with FIFO under most circumstances unless you are absolutely sure that the potential tax break due to a lower Net Income is worth it, because once you switch you’ll be stuck with it unless you get the IRS’ permission to switch back.
There are a lot of other little nuisances to be taken into consideration as well, but these are the basics. If you want more helpful advice, feel free to subscribe and stay updated with new posts to our blog. And if you want to see if the services we offer will benefit you, don’t hesitate to Contact Us.
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