Method: Productivity improvement methods
Managing and maintaining inventory is one of the most important tasks for efficient factory and warehouse operations and can be completed in many different ways. "First in, First Out," or FIFO, and "Last in, First Out," or LIFO, are two common methods of inventory valuation among businesses. The system you choose can have profound effects on your taxes, income, logistics and profitability. Here are the major differences between the two Inventory consists of raw materials, work-in-progress (WIP) products and/or finished goods. Effective inventory management can save an organization significant logistics and operational costs while improving service levels.
Companies operating on the principle of "First in, First Out" value inventory and stock on the assumption that the first goods purchased for resale became the first goods sold. This principle is applied especially when expiration dates of the stored products are important (food, chemical and pharmaceutical industries).
FIFO helps to reduce cost of obsolete inventory and is most commonly used when a manufacturer wants to ensure that its inventory is consumed in the order that it was produced. Financially, FIFO is the most beneficial way to manage inventory because it minimizes outdated products and allows items to move quickly
The "Last In, First Out" method of inventory control using current prices to count a measure called "the cost of goods sold," as opposed to using what was paid for the inventory already in stock. If the price of such goods has increased since the initial purchase, the "cost of goods sold" measure will be higher and thereby reduce profits and tax burdens. Non-perishable commodities like petroleum, metals and chemicals are frequently subject to LIFO accounting.
Advantages of last-in first-out (LIFO) method:-
LIFO matches most recent costs against current revenues:-
The LIFO method provides a better measurement of current earnings by matching most recent costs against current revenues. The non-LIFO methods (such as FIFO method) match old costs against current revenues. When old costs are matched against current revenues in an inflationary environment, the inventory profit (also known as ‘paper profit’ or ‘transitory profit’) is created. Inventory profit occurs when replacement cost of inventory is more than the inventory cost matched against revenues. This inventory profit understates cost of goods sold (COGS) and overstates profit.
The LIFO helps in reducing the inventory profits by matching the most recent costs against revenues. It results in reduction of understatement of cost of goods sold (COGS) and overstatement of profit. Therefore the quality and reliability of earnings are improved under LIFO.
Tax benefits and cash flow advantage:-
The major reason of the popularity of last-in, first-out (LIFO) inventory valuation method is its tax benefit. When LIFO is used in the periods of inflation, the current purchases at higher prices are matched against revenues that alleviate the overstatement of profit and therefore reduce income tax bill. The reduction in income tax results in improvement of cash flows of the company.
LIFO minimizes future risks regarding write-offs:
The net income of a company that uses LIFO is less likely to be affected by decline in price in future. Usually, the companies using LIFO method do not have much inventory at current higher prices because, under this method, most recent inventory purchased at higher price is sold first. So the chances of write-downs to market in future due to decline in inventory prices are minimized or even eliminated under LIFO.
Physical flow of inventory:-
In some situations, the physical flow of inventory corresponds to the LIFO cost flow. For example, in the case of a coal pile, the most recent coal added to the coal pile is always on the top of the coal pile. Therefore, the last coal in is always the first coal out.
This benefit is not a reason of the popularity of LIFO method because the situations where physical flow of inventory corresponds to the LIFO cost flow are very rare to find. The benefit 1, 2 and 3 described above are the main arguments of the widespread employment of this method.
Disadvantages of last-in, first-out (LIFO) method:-
The major drawbacks of using LIFO as inventory costing method are given below:-
Reduced earnings in inflationary times
The LIFO method reduces reported earnings during the periods of inflation. Therefore, many companies fear that an accounting change to LIFO will have a negative effect on investors and will reduce the price of company’s stock because many investors may not be able to understand the impact of LIFO and inflation on the reported earnings.
Understatement of inventory
Under LIFO method, the balance sheet inventory figure is usually understated because it is based on the oldest costs. Due to understatement of inventory, the working capital position may look worse than it really is.
Problem of LIFO liquidation
The LIFO liquidation may inflate the reported income for a given period that results in higher tax payments for the period. To avoid this problem, a company may purchase goods in large quantities with the intention to match them against revenues. Therefore, the adoption of LIFO may develop poor buying habits among companies.
Manipulation of income
A company using last-in, first-out (LIFO) method can easily manipulate its reported earnings for a period by changing its purchase pattern at the end of the year.