By Mansi Dupte
Published on - 13th January 2024
A business's inventory is the collection of items, raw materials, or completed products it keeps on hand for use in its operations, resale, or manufacturing. It is a substantial asset on the balance sheet of a business and includes all goods stored at different points in the supply chain.
The most important inventory components are:
1. Source Materials
2. WIP, or work-in-progress
3. Completed Products
4. Maintenance, Repair, and Operations (MRO) Goods
Types of Inventory are:
1. Cycle Inventory: Standard inventory utilized throughout regular company operations.
2. Safety Stock: Extra inventory is kept on hand to lessen the possibility of stockouts brought on by unforeseen changes in demand or interruptions in the supply chain.
3. Anticipatory Inventory: Stock purchased in advance of future occurrences, such as seasonal demand.
4. Transit Inventory: Goods moving along the supply chain between several sites.
5. Deadstock: Products that are out of style or in extremely low demand.
Maintaining client happiness, cutting expenses, and making sure business operations run smoothly all depend on effective inventory management. It entails weighing the possible expenses of stockouts against the expenses related to inventory keeping.
Inventory, which represents the many phases of commodities during the production and distribution process, is a dynamic and crucial part of a business's assets. Achieving a balance between supply and demand that optimizes profitability and customer happiness requires effective inventory management.
The First-In-First-Out (FIFO) approach of inventory valuation assumes that the units acquired first will be sold first. Stated otherwise, it maintains the inventory's chronological sequence, deducting the cost of the oldest items from the cost of goods sold (COGS) and valuing the last inventory at its most recent expenses.
FIFO is a method used by businesses to streamline balance sheet accounting. A business can value the COGS more in line with the going market price under FIFO. Because inventory costs are reduced, businesses may expect to make more money. Some of the goods that are commonly handled in a FIFO inventory are as follows:
(A) Make Dry Grocery Items
(B) Dairy-based Products
(C) Medical Supplies
(D) Alcohol-based Products
(E) Technology that could be out of date
(F) Gardening
Under FIFO, the cost of goods sold (COGS) may be easily calculated using the following formula:
COGS=Cost of Oldest Inventory Units × Number of Units Sold
In this formula: "Cost of Oldest Inventory Units" refers to the cost of the units from the earliest purchase. "Number of Units Sold" is the number of units sold during a specific period.
This formula says that the oldest inventory units' cost is allocated to the units that are sold first under FIFO. To find the COGS, multiply this cost by the quantity of units sold. This simple formula summarizes the historical approach to inventory valuation used by FIFO.
Let us examine a fictitious situation in which a company purchases a product three times:
Purchase 1:
Quantity: 100 units
Cost per unit: Rs. 5
Purchase 2:
Quantity: 150 units
Cost per unit: Rs. 6
Purchase 3:
Quantity: 200 units
Cost per unit: Rs. 4
Assume that 120 pieces are sold. For COGS, the FIFO calculation would be:
COGS = (100 X Rs. 5) + (20 X Rs. 6) = Rs. 500 + Rs. 120 = Rs. 620
This indicates that the cost of the oldest items is used to calculate the cost of goods sold under FIFO, resulting in a COGS of Rs. 620.
In businesses where product shelf life is important or where prices typically rise over time, FIFO is especially pertinent. It offers an accurate depiction of selling expenses that is consistent with the actual movement of inventory.
The Last-In-First-Out, or LIFO, approach of inventory valuation assumes that the products that have been bought most recently will be the first to be sold. To put it another way, the older, less expensive inventory is left in the ending inventory and the cost of goods sold (COGS) is determined by the cost of the most recent units acquired.
When a fiscal cycle concludes, the LIFO approach frequently necessitates intricate computations. New stock that is sold quickly by a company is worth more than inventory that hasn't been sold yet. Higher inventory costs under LIFO indicate a lesser profit. Typical LIFO inventory items include:
(A) Vehicles
(B) Petrol
(C) Jewelry
(D) Oil
Under LIFO, the cost of goods sold (COGS) is determined using the following formula:
COGS=Cost of Most Recent Inventory Units × Number of Units Sold
In this formula:
"Cost of Most Recent Inventory Units" refers to the cost of the units from the latest purchase.
"Number of Units Sold" is the number of units sold during a specific period.
The basic idea of the LIFO method, which allocates the cost of the most recent units to the ones sold first, is encapsulated in this formula. To find the COGS, multiply this cost by the quantity of units sold.
Imagine a situation in which a company buys a product three times:
Purchase 1:
Quantity: 100 units
Cost per unit: Rs. 5
Purchase 2:
Quantity: 150 units
Cost per unit: Rs. 6
Purchase 3:
Quantity: 200 units
Cost per unit: Rs. 4
Assume that 120 pieces are sold. For COGS, the LIFO calculation is:
COGS = (120 X Rs. 4)= Rs. 480
This indicates that the cost of the most recent units is used to calculate the cost of goods sold per LIFO, resulting in a COGS of Rs. 480.
FIFO assumes that the units purchased are the ones that are sold first.
LIFO presupposes the first units sold are the ones that were obtained last.
FIFO causes the cost of goods sold (COGS) to decrease during inflationary times by prioritizing the utilization of older, less expensive inventory.
LIFO produces a greater cost of goods sold (COGS) in periods of inflation because the cost of the most current inventory is allocated to items sold.
The closing inventory is appraised at prices that are current or higher.
Older or less expensive values are applied to the ending inventory.
FIFO may lead to possible tax benefits by reducing taxable income during inflation.
LIFO might lead to increased COGS, which would short-term reduce reported earnings and taxes.
FIFO more closely adheres to the matching principle by matching income with an older, less expensive inventory.
LIFO may maybe less faithful to the matching concept when there is inflation.
FIFO usually causes the balance sheet's ending inventory value to increase.
LIFO might result in a reported lower inventory value.
In general, FIFO is easier to use and comprehend.
LIFO can be more complicated because of factors like taxes, inflation, and financial reporting.
FIFO is preferred in markets with steady or increasing pricing.
LIFO is often employed during inflationary times or in businesses with volatile costs.
The decision between the LIFO (last-in-first-out) and FIFO (first-in-first-out) inventory valuation techniques is based on several variables, and neither approach is always "better" than the other. Each method's acceptability is determined by the financial goals, industry norms, and unique circumstances of the organization. The following factors apply to both approaches
Better Reflects Cost:
In many businesses, FIFO tends to more accurately represent the real movement of inventories. It is consistent with the natural flow of products, which assumes that the oldest inventory would be sold first.
Matches Revenue and Costs:
By matching older, lower-cost inventory with revenue, FIFO more closely follows the matching principle and presents a more accurate picture of profitability.
Higher Ending Inventory Valuation:
When prices are rising, FIFO usually means that the balance sheet's final inventory valuation is greater.
Lower Tax Impact:
Lower taxable revenue and tax benefits are two possible outcomes of FIFO, particularly in inflationary times.
COGS Reflects Current Costs:
The cost of goods sold (COGS) is adjusted to account for the current cost of inventory (LIFO), which might be beneficial when prices are rising and inflation is present.
Potential Tax Benefits:
In the near run, LIFO may result in lower reported earnings and lower taxes, which might improve cash flow, particularly in sectors with volatile pricing.
Matching with Revenue:
LIFO may be a more effective method of aligning the cost of products sold with revenue in some sectors where costs are subject to frequent changes.
In the end, several variables, including industry standards, particular company needs, tax ramifications, and financial reporting goals, affect the decision between FIFO and LIFO. While some businesses may pick LIFO due to its possible tax benefits and greater alignment with current expenses, many choose FIFO due to its simplicity and adherence to the matching principle. To choose the best course of action, it is crucial for firms to thoroughly evaluate their particular situations and confer with financial experts.
Basis of Valuation:
FIFO: presumptively the initial units purchased are the initial ones sold.
LIFO: assuming the first units sold are the ones that were obtained last.
Weighted Average Cost: uses the weighted average of unit expenses to get an average cost.
COGS Calculation:
FIFO: results in decreased COGS during times of inflation.
LIFO: leads to increased COGS during times of inflation.
Weighted Average Cost: balances off price swings and offers a moderate strategy.
Ending Inventory Valuation:
FIFO: Valued at the going rate or a higher one.
LIFO: Valued at a lesser cost or age.
Weighted Average Cost: A combination of newer and older products, valued at average cost.
Tax Implications:
FIFO: This might lead to a decrease in taxable income when inflation rises.
LIFO: May, in the near run, lead to reduced taxes as a result of greater COGS.
Weighted Average Cost: The tax effect lies in the middle of LIFO and FIFO.
Complexity:
FIFO: In general, easier to use and comprehend.
LIFO: Can be more complicated, particularly when it comes to financial reporting, taxes, and inflation.
Weighted Average Cost: This is quite intricate, requiring the computation of weighted averages.
Balance Sheet Impact:
FIFO: Usually yields an increased ending inventory value.
LIFO: This might result in a reported lower inventory value.
Weighted Average Cost: Offers a balance between the ending inventory value methods of FIFO and LIFO.
Industry Preferences:
FIFO: Preferred to markets with steady or increasing pricing.
LIFO: Often employed during inflationary times or in businesses with volatile costs.
Weighted Average Cost: Extensively utilized across several sectors, offering a middle ground between FIFO and LIFO.
The decision between Weighted Average Cost (WACC), LIFO, and FIFO is influenced by several elements, including industry standards, tax consequences, and the particulars of the company. Every approach has benefits and drawbacks, therefore the choice should be in line with the financial plans and objectives of the business.
We have tried to cover all the most significant aspects related to FIFO (First-In-First-Out) and LIFO (Last-In-First-Out) in-depth with real-life examples. In this blog, we discussed what is inventory, what is inventory management, what is FIFO and its formula with an example, what is LIFO and its formula with an example, a comparison between FIFO and LIFO, which one is better between these two, and also a comparison of FIFO, LIFO, and Weighted Average Cost.
I hope now you’ve understood all these terms.
Thank you so much for reading :)