LIFO vs FIFO: Which is Better?

April 11, 2024 - 12 minutes read

Weighing the pros and cons of these established inventory rotation methods.

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As restaurants and retail stores grapple with expiration dates, spoilage, and spiraling costs, systems designed to consume the oldest items first, or first-in, first-out (FIFO), are a foregone conclusion. But in the world of inventory management, there is another less intuitive option, known as last-in, first-out (LIFO), that can sometimes provide a better solution.

The idea of using up newer items first while leaving older products to gather dust might seem counterintuitive. As they say, out with the old, in with the new. This traditional viewpoint discounts the impact of inventory valuation and cost of goods sold (COGS) on inventory management practices. We take a closer look at LIFO and FIFO and explore their benefits and drawbacks to demystify this important topic.

“The only way to get ahead is to find errors in conventional wisdom.” – Larry Ellison

What is FIFO?

As the name implies, first-in, first-out (FIFO) is a system used to cycle inventory where the earliest items received or produced are always consumed first. For example, soda machines and supermarket dairy aisles are organized so that the oldest stock is automatically moved closer to customers. This method is ideal for situations where spoilage or obsolescence are a concern.

In most cases, older purchased or manufactured items will also have a lower value or COGS. When inventory audits and cycle counts are performed, remaining items are valued based on their initial cost, so an imbalance of newer products drives up the overall inventory value. This makes it advantageous to turn inventory over promptly with the FIFO method.

What is LIFO?

The last-in, first-out (LIFO) method of inventory rotation is based on selling the newest items first. In a retail setting, this means putting the newest items in front while allowing older items to go unsold. Obviously, this system only makes sense for non-perishable items and products that don’t run the risk of obsolescence.

For accounting purposes, valuation typically drops when you retain older inventory. For example, if an auto dealership purchased 75 new cars of the same model earlier in the year, for a lower price, and 25 later in the year, for a higher price, the weighted average of all available cars on the lot would drive the overall inventory value down. 

Which method is better?

Deciding between LIFO and FIFO can be a difficult decision, especially when the inventory you manage is a mixture of perishable and more stable product types. Many companies utilize both methods, depending on the situation. Advanced inventory management software makes it easier to navigate these complex scenarios. To find out which method will work best for you, it helps to review their benefits and drawbacks.

LIFO vs FIFO: Side-By-Side

 

LIFO	FIFO
Recent costs reflect current market prices.	Oldest inventory items sold first.
Higher cost of goods sold (COGS) during inflationary periods.	Lower cost of goods sold (COGS) during inflation.
Tax advantages in times of rising prices.	Tax drawbacks with rising prices.
Lower inventory valuation with inflation.	Higher inventory value with inflation.
The matching principle may not be accurate.	Better matches revenues with costs.
May lead to lower reported profits.	May lead to higher reported profits.
Results in higher inventory levels.	Results in lower inventory levels.
Higher cash flows due to lower taxes.	Lower cash flows due to higher taxes.
Complex record-keeping for specific costs.	Simple record-keeping without specific costs.
Risk of inventory obsolescence.	Reduced risk of inventory obsolescence.
May distort the true cost of goods sold.	Typically aligns with actual flow of goods.
Encourages holding onto older inventory.	Older inventory must move first.
May lead to higher carrying values.	May lead to lower carrying values.
Depreciation impact on inventory values.	Effective for income smoothing.

 

Advantages of FIFO

The biggest advantage of FIFO lies in its simplicity. Following the natural flow of the inventory makes it easier for warehouse managers and workers to organize stock and recognize slow-moving items. Ensuring the first items acquired are the first items sold also reduces waste or scrap by consuming product before it can expire or become obsolete.

The FIFO method allows you to turn inflation in your favor when you sell an item that was purchased at a lower cost months later for a higher, inflationary price. FIFO also simplifies accounting methods by leaving only the newest items on the shelf (reflective of the current market value) at the end of each month.

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” – Milton Friedman

Drawbacks of FIFO

Many of the disadvantages of FIFO are related to bookkeeping and taxes. FIFO is based on the oldest goods always being sold first, which means COGS will typically be lower and the profit margin higher. Although this helps the bottom line, it can hurt businesses come tax season. Additional drawbacks of FIFO include:

• Responsibility for tracking and organizing items according to age
• Risk of expiration if too much inventory is on hand
• Higher risk of stockouts when reorder points are lower

Item valuation is always in flux using the FIFO method, so the chances of clerical errors also go up. Since it focuses on the order of acquisition, FIFO can mask underlying demand patterns or seasonal variations that help to optimize inventory levels.

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Advantages of LIFO

In our everyday lives, we usually consume what we’ve had the longest before opening something new. This is especially true for products like milk and eggs that have a limited shelf life. So why would we want to flip the script and use up newer items first? The answer is primarily based on accounting principles. Last-in, first-out (LIFO) inventory rotation allows you to:

• Reduce inventory valuation by keeping older (lower cost) items on the shelf
• Minimize taxes by shrinking the recorded profit margin
• Align COGS with revenue to mitigate the impact of inflation over time
• Incentivize buyers to take advantage of low cost purchasing opportunities

Of course, these financial perks are based on prices consistently rising, which is typically the case. In times of deflation, these benefits are no longer valid. Outside of the accounting advantages, LIFO can make it easier to stock items in some retail and warehouse environments, since it eliminates the need to physically rotate products.

Disadvantages of LIFO

The inherent tax benefits of LIFO are based on an accompanying loss in earnings. This can be especially concerning for public companies that must report their earnings regularly. LIFO is also banned in countries outside of the United States that operate under the International Financial Reporting Standards (IFRS), rather than the generally accepted accounting principles (GAAP) followed in the U.S.

The LIFO method is not compatible with lean methods like just-in-time inventory management that rely on the natural flow of goods through the supply chain to regulate purchase orders and keep inventory levels as low as possible. Of course, LIFO also becomes impractical in situations where shelf-life or obsolescence factor in, unless inventory turns over fast enough to negate these issues.

The aforementioned accounting benefits also come with some strings attached. Additional record-keeping and documentation are required to keep track of ongoing inventory cost changes. This added complexity in financial reporting should be weighed against the perceived value of LIFO.  

Inventory rotation best practices

Whether you choose LIFO, FIFO, or a combination of both, it is important to implement some logical inventory rotation best practices to ensure efficient utilization of items and minimize the risk of obsolescence or spoilage. Important tasks and processes to consider when establishing your inventory rotation strategy include:

• Creating a system with clear responsibilities, schedules, and tracking methods
• Training employees on proper inventory rotation methods
• Monitoring expiration dates and inventory locations regularly
• Utilizing barcode scanning to track warehouse inventory in real-time
• Leveraging inventory management software to keep track of inventory levels, automate inventory rotation processes, and generate reports.

Inventory rotation practices are mandatory in regulated industries including food and cosmetics, where the time-sensitive nature of the product can create health risks for consumers if not carefully controlled and monitored. Rotation is also important in industries with perpetual product changes, including electronics, automotive, and fashion.

LIFO vs FIFO: Final thoughts

LIFO and FIFO are much more than industry buzzwords. Depending on the specific products, cycle times, and accounting methods in place, the choice between these two common practices can significantly impact the bottom line of any business. That is why these methods are continually scrutinized and optimized by industry leaders including Amazon, Best Buy, and Walmart.

With a suite of software solutions encompassing inventory management, warehouse management, point of sale (POS), and full-featured customer relationship management (CRM) that integrate seamlessly with your favorite E-commerce applications, Agiliron allows you to leverage the latest mobile inventory management technology to optimize your rotation processes and facilitate accurate and timely inventory valuation.

Successful LIFO or FIFO implementation requires robust inventory monitoring to meet stringent accounting standards. These tasks are simplified with the help of versatile, cloud-based inventory management software. We can help you weigh the pros and cons of LIFO and FIFO to decide which method is right for your business. Contact us today and allow one of our solution experts to help you make this important decision.

Tags: inventory management