FiFO/ LIFO EXPLANATION WITH EXAMPLES

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FIFO stands for “First-In, First-Out”. It is a method used for cost flow assumption purposes in the cost of goods sold calculation. The FIFO method assumes that the oldest products in a company’s inventory have been sold first. The costs paid for those oldest products are the ones used in the calculation.

How Do You Calculate FIFO?

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.

The “inventory sold” refers to the cost of purchased goods (with the intention of reselling), or the cost of produced goods (which includes labor, material & manufacturing overhead costs).

Keep in mind that the prices paid by a company for its inventory often fluctuate. These fluctuating costs must be taken into account.

For instance, if a business sold 100 units of an item, and 75 units were originally purchased by the company at $10.00 and 25 units were purchased at $15.00, it cannot assign the $10.00 cost price to every unit sold. Only 75 units can be. The remaining 25 items must be assigned to the higher price, the $15.00.

Lastly, the product needs to have been sold to be used in the equation. You cannot apply unsold inventory to the cost of goods calculation.

The advantages to the FIFO method are as follows:

• The method is easy to understand, universally accepted and trusted.
• FIFO follows the natural flow of inventory (oldest products are sold first, with accounting going by those costs first). This makes bookkeeping easier with less chance of mistakes.
• Less waste (a company truly following the FIFO method will always be moving out the oldest inventory first).
• Remaining products in inventory will be a better reflection of market value (this is because products not sold have been built more recently).
• Higher profit.
• Financial statements are harder to manipulate.

The FIFO method gives a very accurate picture of a company’s finances. This information helps a company plan for its future.

What Are the Disadvantages of FIFO?

company also needs to be careful with the FIFO method in that it is not overstating profit. This can happen when product costs rise and those later numbers are used in the cost of goods calculation, instead of the actual costs.

FIFO EXAMPLE

Peter’s Sunglasses is a sunglass retailer located in London, UK. Peter opened the store in September of last year. Right now, it is just the one location but he may expand in the next couple of years depending on whether he can make good money or not.

January has come along and peter needs to calculate his cost of goods sold for the previous year, which he will do using the FIFO method.

Here is what his inventory costs are:

Month             Amount                   Price Paid

September      200 sunglasses      $200.00 per
October           275 sunglasses      $210.00 per
November      300 sunglasses       $225.00 per
December      500 sunglasses       $275.00 per

peter sold 600 sunglasses during this time, out of his stock of 1275..

Going by the FIFO method, Sal needs to go by the older costs (of acquiring his inventory) first.

Peter’s COGS calculation is as follows:
200 x $200.00 = $40,000.
275 x $210.00 = $57,750.
125 x $225.00 = $28,125.
COGS Total:   $125,875.

peter’s cost of goods sold is $125,875.

The remaining unsold 275 sunglasses will be accounted for in “inventory”.

Sal can use the cost of goods sold to help determine his profit.

Example  02

Going back to our retailer for example, let’s assume the five shirts that were purchased in May costs $7 per shirt. The shirts purchased in June cost $8.50 per shirt.

If the company sold 5 shirts for the year, Fifo would report costs of goods sold as $35 (5 shirts purchased in May at $7 per shirt). This FIFO cost does not take into full consideration the newer $8.50 per shirt cost of restocking the inventory. In fact, by the time to company will have to purchase more inventory the costs might go up even more than $8.50.

Thus, the FIFO method reports lower costs of goods sold on the income statement and tax return than the company actually incurred for the year. This is a common technique that management uses to increase reported probability. This reporting does have a downside, however. Lower costs and higher profit  translates in to higher levels or taxable income and more taxable due.

Example  03 ( this  example use for explain to LIFO method also.)

Bee’s Lighting buys and resells lamps. Here’s a look at what it’s been costing Bee to build up his inventory since his store opened:

Month	Amount	Price Paid
October	100 lamps	$50.00 per
November	100 lamps	$85.00 per
December	100 lamps	$100.00 per

Bet’s say on January 1st of the new year, Bee wants to calculate the cost of goods sold in the previous year. Lee has sold 80 lamps so far.

COGS calculation is as follows:

80 x $50.00 = $4000.

(Because Bee is going by the FIFO method, he is using the oldest cost of $50.00 per lamp in the calculation.)

How Do You Calculate LIFO?

To calculate COGS (Cost of Goods Sold) using the LIFO method, determine the cost of your most recent inventory. Multiply it by the amount of inventory sold.

As with FIFO, if the price to acquire the products in inventory fluctuate during the specific time period you are calculating COGS for, that has to be taken into account.

Here is  LIFO methods calculation (EXAMPLE 03)

It looks like Lee picked a bad time to get into the lamp business. The costs of buying lamps for his inventory went up dramatically during the fall, as demonstrated under ‘price paid’ per lamp in November and December. So, Lee decides to use the LIFO method, which means he will use the price it cost him to buy lamps in December.

COGS calculation is as follows:
80 x $100.00 = $8,000.
(Because Lee is going by the LIFO method, he is using the most recent cost of $100.00 per lamp in the calculation.)

Although using the LIFO method will cut into his profit, it also means that Bee will get a tax break. The 220 lamps Bee has not yet sold would still be considered inventory.

The difference between the LIFO and FIFO calculation is $4000. That difference is called the LIFO reserve. It is the amount by which a company’s taxable income has been deferred by using the LIFO method.

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