When it comes to small business inventory management, it really does come down to three inventory valuation approaches; LIFO, FIFO and Average Cost. Every small business is concerned about inventory cost control. After all, inventory is often a company’s biggest asset on its balance sheet and its most important tool in winning new business. Because inventory can be in several semi-finished and finished states, valuing this inventory has considerable implications for your company’s gross profit and net income.
Inventory control systems typically offer companies an opportunity to use a variety of costing methods with respect to the company’s inventory. Which leads us to discussing the most prevalent inventory costing methods; the aforementioned LIFO (Last-In First-Out), FIFO (First-In First-Out), and Average Cost. So, what are the difference between all three, and what if any advantage does one have over the other?
Assessing a Value to Inventory
When looking at assessing the value of your inventory, be cognizant of the fact that each of these inventory costing methods impacts your company’s balance sheet, its income statement and cash flow statement in different manners. Therefore, in discussing LIFO, FIFO and Average cost, it’s essential to touch on how each plays a role among the three predominant financial reporting structures companies use – Balance Sheet, Income Statement, and Cash Flow Statement.
When determining inventory value, one must perform the final inventory calculation. Choosing LIFO or FIFO has very different implications for your company’s final inventory value among the three financial statements mentioned above. A lower inventory valuation (LIFO) or higher inventory valuation (FIFO) would affect the cash flow statement, balance sheet and income statement differently and will apply a different value to the inventory in each case.
Final Inventory Calculation:
- Final Inventory = (Beginning Inventory + New Purchases) – Cost of Goods Sold “COGS”
Balance Sheet: Without going into too much detail, a company’s balance sheet is somewhat of a photograph in time. It’s not fixed, and can change. It provides a time-sensitive “snapshot” that explains how much a company owns (its assets) and what it owes (its liabilities). These assets and liabilities can change over time. The final inventory value is represented on the balance sheet among a company’s assets.
Income Statement: An income statement represents a company’s profitability during a specific period. In this sense, the income statement is more about tracking a company’s revenues and its expenses. The income statement is often used to update income from quarter to quarter within a company’s fiscal year. The “COGS”, Cost of Goods Sold appear on the company’s income statement through its assessment of its sales efforts.
Cash Flow Statement: The cash flow statement explains the sources of the company’s incoming cash over a specific period and its amount owing to bank loans, equipment, miscellaneous payments and taxes. One item always included on a cash flow statement is inventory.
Inventory Valuation Methods: FIFO vs. LIFO vs. Average Cost
FIFO (First In First Out): This inventory valuation method means those products that arrive in inventory first, are first to be sold. So, if your company purchased inventory of widgets in April at $2.00, May at $2.25 and June at $2.35, then the April inventory ($2.00) would be the first widget sold. This helps to provide a better value for the final inventory calculation because it guarantees original inventory is sold first – thereby protecting against damage and inventory obsolescence over time.
Because inflation implies that prices rise over time, those products that are first into your company’s inventory will have a lower cost than newer inventory. FIFO increases your company’s gross profit by matching sales with lower inventory valuated products. This not only increases your company’s gross profit, but its net income as well. Unfortunately, higher profit and income mean a higher tax burden or liability.
FIFO Income Statement Example:
Here’s an example of how FIFO looks on an Income Statement. With this inventory method, the company’s COGS are lower and ending inventory is higher. This is because the earlier inventory is used first and we’ve matched sales with this lower valued inventory.
Calculations: COGS, Gross Profit & Net Profit in above table
- COGS (Beginning Inventory + New Purchases) – Ending Inventory = ($6,000.00 + $10,000.00) - $10,000 = $6,000.00
- Gross Profit: Sales – “COGS” = $15,000.00 - $6,000.00 = $9,000.00
- Net Profit: Gross Profit – Expenses = $9,000 - $2,500.00= $6,500.00
LIFO (Last In First Out): This inventory method implies that the most recent received product into inventory is the first to be sold. Again, referring to our example above, if your company purchased inventory of widgets in April at $2.00, May at $2.25 and June at $2.35, then the June inventory ($2.35) would be the first widget sold.
LIFO isn’t a good value for the final inventory calculation because it forces companies to hold older inventory longer – which increases the likelihood that these items could become damaged. Because inflation and rising prices are a given over time, this means the most recent product into your inventory is more costly.
LIFO decreases your company’s gross profit by matching sales with higher inventory valuated products. Lower gross profit means a lower net income, but does mean a lower tax amount on profits. It’s interesting to note that LIFO is banned in the UK as an official method of business accounting and inventory valuation.
LIFO Income Statement Example:
Here’s an example of how LIFO looks on an Income Statement. With this inventory valuation method, the COGS are higher and ending inventory value lower. We have a lower inventory value because the last inventory purchased is more expensive and we’ve matched our sales to this higher valued inventory.
Calculations: COGS, Gross Profit and Net Profit in above table.
- COGS (Beginning Inventory + New Purchases) – Ending Inventory = ($6,000.00 + $10,000.00) - $5,000 = $11,000.00
- Gross Profit: Sales – “COGS” = $15,000.00 - $11,000.00 = $4,000.00
- Net Profit: Gross Profit – Expenses = $4,000 - $2,500.00= $1,500.00
Average Cost: Average cost simply takes a weighted average of inventory costs over time and assigns this value to the inventory. It can be seen as a value that is neither a negative nor a positive in the sense that it doesn’t discriminate between “first-in, first-sold” or “last-in, first-sold”.
An Example of LIFO vs. FIFO vs. Average Cost in Inventory Valuation
Let’s go back to our example of your company purchasing inventory of widgets in April at $2.00, May at $2.25 and June at $2.35. In each of these months, your company purchased 200, 300 and then 400 of these widgets. These purchases are represented in the table below.
- Total Volume Ordered: 900 Units
- Total Inventory Value: $2,015.00
- LIFO Assumes that the June Inventory is sold first = $2.35
- FIFO Assumes that the April Inventory is sold first = $2.00
- Average Cost applies a “weighted” average to inventory = $2.23
Calculating Weighted Average Cost: Since the cost per unit and volume ordered fluctuates, a heavier volume might correlate to various prices. In order for the weighted average to be truly representative, use the following calculation:
{(April Price X Volume) + (May Price X Volume) + (June Price X Volume)} / Total Volume Ordered
{($2.00 * 200) + ($2.25 * 300) + ($2.35 X 400)}/ 900
{($400) + ($675) + ($940)} / 900
$2015/900 = $2.23 Weighted Average Cost
From a small business inventory management perspective, it’s important to note that both FIFO and LIFO require additional tracking mechanisms in order to draw upon certain inventory. While inventory tracking is essential in batch control and ensuring quality, it does seem like an added burden to impart upon inventory management systems when running either of these inventory methods.
Since most of my customers aren’t publicly traded companies, I often advise them to avoid the FIFO and LIFO inventory valuation and go straight for weighted average cost. Companies seem to enjoy playing around with their profit – which is certainly something that can be done with either of these inventory valuation methods. These methods can overly-inflate, or drastically underestimate, a company’s overall net income and value. While I can see some benefit with FIFO from an overstated earnings per-share (EPS), higher profit and net income standpoint, it does result in a higher tax burden.
Investors often aren’t in tune with analyzing a company’s inventory valuation and probably won’t notice the subtle differences between LIFO & FIFO. From my perspective, small business inventory management should be as painless as possible. There are enough issues as it is, without having to play around with a sometimes convoluted LIFO & FIFO approach to inventory management.
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