Competing Methods of Managing Your Finances
LIFO and FIFO are common accounting techniques used to determine the financial value of unsold inventory, raw materials, parts, components, or feed stocks that need to be reported at the end of every accounting period. The LIFO and FIFO methods are used to manage assumptions of cost and cash flow related to inventory, and corporate stock repurchases.
FIFO stands for first-in, first-out, meaning that the oldest unsold items in your inventory are recorded as sold first, regardless of which physical item has been packaged, tracked, and shipped.
Conversely, LIFO stands for last-in, first-out, meaning that the most recently produced or purchased items are recorded as sold first. Since the 1970s, many U.S. companies have shifted away from the FIFO method in order to capture specific tax benefits during inflationary periods. The United States is the only country that allows the use of LIFO accounting techniques.
Picking a Method
Under LIFO, the assumption is that your most recent (and therefore most expensive) purchases are the first items sold, therefore the cost of goods sold is relatively higher, and the value of the goods remaining on your balance sheet is somewhat lower. So why would a small-business owner choose the LIFO method? Where does business strategy come into play?
If you believe that your inventory costs are stable and likely to remain so, then the LIFO approach can help your business save money on the back end: lower profits mean lower taxes and higher cash flow. Think of the LIFO as a deferred tax advantage. FIFO accounting, on the other hand, can help your business maintain a more accurate valuation of inventory.
If you sell products as a retailer or a manufacturer and the cost of your supplies or raw materials tends to increase over time (as most costs due), then using the LIFO method will typically result in lower net taxable income. But keep in mind that if you need to maintain a strong balance sheet for the purpose of raising capital, FIFO can help “pad” your company’s financial statement.