In contrast, LIFO results in higher COGS and lower reported gross income. Using HIFO can lower taxable income by prioritizing the sale of higher-cost inventory, reducing gross profit. However, this can also lower net income, potentially affecting financial ratios and investor perceptions.

Sell Through Rate: A Key Metric for Inventory Management

• This means that ‘first in’ inventory has a lower cost value than ‘last in’ inventory.
• In the following section, we will look at the different techniques of inventory valuation and share some pointers which can help you choose the right technique for your business.
• So assume that 1 batch of 100 units is produced within each period, and the cost of production increases after each successive period.
• While it has some disadvantages, such as higher taxes, its benefits outweigh the drawbacks for most businesses.
• Applying HIFO to stocks involves selling shares with the highest purchase price first, which can minimize capital gains taxes in a rising market.
• Industries with strict regulations regarding expiration dates, such as food and pharmaceuticals, should consider FEFO.

Thus, businesses that choose FIFO will try to sell their oldest products first. FIFO inventory valuation is the default method; if you do nothing to change your inventory valuation method, you must use FIFO to cost your inventory each year. As you might guess, the IRS doesn’t like LIFO valuation, because it usually results in lower profits (less taxable income). But the IRS does allow businesses to use LIFO accounting, requiring an application, on Form 970.

HIFO requires businesses to consistently apply the method to all inventory items within a category to meet standards like GAAP or IFRS. This involves tracking the cost basis of assets to identify the highest-cost items for sale first. Effective implementation demands robust inventory systems capable of handling detailed data and ensuring accurate financial reporting. In cases where the cost of goods rises sharply, FIFO might not reflect current market costs accurately.

The sum of $6,080 cost of goods sold and $7,020 ending inventory is $13,100, the total inventory cost. In this case, the store sells 100 of the $50 units and 20 of the $54 units, and the cost of goods sold totals $6,080. Let’s assume that a sporting goods store begins the month of April with 50 baseball gloves in inventory and purchases an additional 200 gloves. Goods available for sale totals 250 gloves, and the gloves are either sold (added to cost of goods sold) or remain in ending inventory. If the retailer sells 120 gloves in April, ending inventory is (250 goods available for sale – 120 cost of goods sold), or 130 gloves. For example, the seafood company—from the earlier example—would use their oldest inventory first (or first in) when selling and shipping their products.

Main inventory accounting methods

It ensures resource optimization, real-time monitoring, and full process control, supporting all inbound, outbound, and internal logistics activities. Although not as widely recognized as LIFO (Last In, First Out) or FIFO (First In, First Out), HIFO offers unique advantages and challenges. Examining its characteristics alongside traditional methods reveals valuable insights into its applications and benefits. This Bplans document is one of many business plan templates you could benefit from during your entrepreneurial journey. With each of these options, it’s just a matter of downloading the template and then filling in the spaces with your corporate details.

How to record inventory and cost of goods sold

Accountants use “inventoriable costs” to define all expenses required to obtain inventory and prepare the items for sale. For retailers and wholesalers, the largest inventoriable cost is the purchase cost. Multiply the cost of your oldest inventory per unit by the number of units sold. However, if inventory has been stagnant for some time, this method may not reflect the actual cost of materials, especially in an inflationary environment. LIFO, or Last In, First Out, assumes that a business sells its newest inventory first.

LIFO inventory values

• LIFO is not permitted under international financial reporting standards (IFRS)—something to be aware of if you do business internationally.
• FIFO, or First In, First Out, is an inventory valuation method that assumes that inventory bought first is disposed of first.
• However, FIFO is a much more popular method out of the two because of being more logical for most industries.
• FIFO and LIFO are basically opposites of each other, and FIFO is more commonly practiced.
• FIFO is generally accepted as the more accurate inventory valuation system.
• According to the Internal Revenue Service (IRS), if your business is holding inventory, you are required to use the accrual method of accounting.

This gives different results depending on whether you use a periodic inventory system or a perpetual inventory system. This can add complexity because you need to track older stock that isn’t considered “sold” yet. If you run a company that supplies perishable goods such as fresh food, it’s the only logical way to operate. This often aligns with how many businesses naturally operate—especially those dealing with perishable goods. The formulas for calculating FIFO and LIFO focus on determining the COGS and ending inventory, depending on the sequence of inventory usage or sale.

You should also know that Generally Accepted Accounting Principles (GAAP) allow businesses to use FIFO or LIFO methods. However, International Financial Reporting Standards (IFRS) permits firms to use FIFO, but not LIFO. Check with your CPA to determine which regulations apply to your business. When you sell the newer, more expensive items first, the financial impact is different, which you can see in our calculations of FIFO & LIFO later in this post.

Top 5 Differences

Under the LIFO method, the 100 units sold in March would be valued at $7 each (from the February purchase), and the remaining 50 units would be valued at $5 each (from the January purchase). It is the amount by which a company’s taxable income has been deferred by using the LIFO method. Although using the LIFO method will cut into his profit, it also means that Lee will get a tax break.

The key term fifo or lifo inventory methods here is interpretation, as these methods are used for reports and the inventory amount is an estimate, not an exact value. It’s an estimate that is calculated by a variety of methods, each resulting in a different number. So, LIFO and FIFO do not reflect what has actually happened in a company’s bank account, rather, it’s just how they are reporting it.