FIFO vs. LIFO: How They Affect Your Bottom Line

From shelf life to expiry date to holding costs, ecommerce inventory management involves the consideration of numerous factors specific to individual products. Most ecommerce businesses base their decisions on which items go out when using either the First In, First Out (FIFO) method or the Last In, First Out (LIFO) method. Choosing between FIFO vs. LIFO is a big decision that can significantly impact operational costs, tax liability, and more. This article explains what you need to know before making a call. 

What Is FIFO?

FIFO, or ‘First In First Out,’ is an inventory valuation method where the oldest items in inventory (the first ones in) are assumed to be sold first. Under FIFO, the Cost of Goods Sold (COGS) is based on the cost of the earliest purchased materials, while the remaining inventory is valued at the cost of the most recently purchased goods.

The FIFO method is recognized by both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). It’s generally considered the most practical of the two inventory valuation methods – we’ll explain why later on.

What Is LIFO?

LIFO, which stands for ‘Last In First Out,’ is an alternative method to FIFO. With LIFO, the newest items put into stock are the first ones to be sold or used. This means the cost of the most recently produced or purchased inventory is the first to be expensed as COGS, and the oldest remains accounted for in existing inventory balance sheets. 

There are cases where using LIFO might make sense, such as when a company’s COGS is higher and its profits are lower. However, this valuation method is only recognized in the United States’ GAAP – IFRS cites its risk of distorting profitability and financial statements. 

How FIFO and LIFO Influence Income

Total cost doesn’t change under FIFO or LIFO accounting systems. The order in which they consider costs, however, can impact both balance sheets and income statements. As prices fluctuate over time, the value of individual units in inventory changes. 

Inflation is the most common reason for this. Consider a company that purchased a shirt in bulk for $10 a unit two years ago. The same shirt costs $15 a unit today. Under FIFO, the $10 shirt would be sold first, resulting in lower COGS and higher profits. The ending inventory value would be higher as the shirts remaining in inventory cost $15.

If the $15 shirt is sold first under LIFO, the COGS would be higher, and the profit margin smaller. The ending inventory value would be lower because each shirt in inventory only cost $10 to initially purchase. 

It’s worth noting that there is a medium between these two points – if all items in a company’s inventory are sold, all goods go into COGS regardless of their initial purchase price. This is relatively rare, however, and also something to avoid, given the negative impacts stockouts have on customer satisfaction. The reorder point formula and several other supply chain KPIs can help optimize buffer inventory levels under either inventory valuation method. 

The Financial Effects of FIFO vs. LIFO

Let’s put the above explanation into context with a more in-depth example: 

ABC Skincare sells a line of popular facial cleansers. For the simplicity of this scenario, we will assume that their beginning inventory is at zero. Their purchase records for one product in April 2024 are as follows: 

FIFO Method

Now, let’s say ABC Skincare sold 50 bottles of cleanser on the 10th of April and another 100 bottles on the 22nd of April. This would bring its ending inventory balance to 350. The value of that balance will differ between the FIFO and LIFO methods. 

If the oldest inventory is sold first, all 150 bottles of cleanser sold were initially purchased for $55 on April 12th. See how this affects COGS and ending inventory calculations below. 

COGS

150 bottles of cleanser from the oldest inventory x $50 supplier price per unit = $7,500

Ending Inventory

Remaining inventory:

• 50 bottles from April 3rd purchase = 50 x $50 = $2,500
• 100 bottles from April 12th purchase = 100 x $55 = $5,500
• 200 bottles from April 27th purchase = 200 x $56 = $11,200

Total ending inventory value = $2,500 + $5,500 + $11,200 = $19,200.

LIFO Method

ABC Skincare could also use the LIFO inventory valuation method. In such a case, the most recently purchased and more expensive ($56) inventory would be shipped to customers, and the remaining amount would be kept in storage. This creates different results, as elaborated below. 

COGS

150 x $56 = $8,400

Ending Inventory

Remaining inventory: 

• 200 bottles from April 3rd purchase: 200 x $50 = $10,000
• 100 bottles from April 12th purchase: 100 x $55 = $5,500
• 50 bottles from April 27thpurchase: 50 x $56 = $2,800 

Total ending inventory value = $10,000 + $5,500 + $2,800 = $18,300

Noting the Difference

The math we just did shows a $1,900 difference in COGS and ending inventory for FIFO and LIFO, with the former method resulting in a lower ending inventory balance of $16,400. Note that in both cases, the total amount of money at play is the same: adding the COGS amount with the ending inventory value equals $26,700 for both methods.

Why It Matters

Whether that $1,900 falls on COGS or ending inventory matters when profit is brought into the equation. In our scenario, ABC Skincare sells its moisturizer for $100 per bottle online. FIFO would see 150 of the $50 units sold with a $50 margin each, while a LIFO system would mean selling the $56 units first at a $44 margin. 

Multiplied by the total number of purchases in April, that amounts to respective net profits of $7,500 and $6,600 for a total difference of $900 in realized income.

FIFO vs LIFO vs Other Inventory Valuation Methods

If you’ve already done some reading about popular inventory valuation methods, you’re likely wondering how weighted average cost and specific identification fit into the FIFO vs LIFO method comparison.  

Weighted average cost calculates the average cost of all items in inventory by dividing the total cost of goods available for sale by the total number of units available for sale. The resulting weighted average cost per unit can then be broadly assigned to COGS and ending inventory. It doesn’t consider the purchase date or account for variations in the value of goods over time. 

Specific identification is essentially the opposite, requiring businesses to value inventory on an individual basis. This is an extremely complex job that only really makes sense in the case of high-value or custom products. 

FIFO and LIFO are more broadly practiced because they offer reasonably straightforward frameworks for accurately valuing inventory over time.

FIFO vs LIFO: Which Is Better for Your Ecommerce Business?

Both bookkeeping and logistics are affected by the decision to use FIFO over LIFO or vice versa. There’s no ‘better’ approach – the right option for your business will depend on the specific operating model, market, and supply chain at hand. Below, we outline factors to consider when choosing between FIFO vs LIFO. 

Exposure to Price Volatility

LIFO is useful in industries that see frequent changes in inventory value. Price swings are especially common for production processes dependent on commodities like rare metals and gas, which may climb or drop in value as the result of economic events, political disputes, and natural disasters. 

A resilient supply chain with diverse suppliers can help secure the lowest prices possible in any case, while LIFO ensures that current cost is properly reflected on financial statements. 

Inventory Turnover

The inventory turnover ratio can indicate the suitability of FIFO vs. LIFO for specific circumstances. For products with high turnover rates and no shelf life, a comprehensive lot tracking system like LIFO might not be necessary. 

Companies with high turnover rates across the board would save more time with the FIFO method. However, those who can’t risk leaving old inventory to spoil in a warehouse or fulfillment center might consider the extra work of LIFO worthwhile. 

Tax Liability

Taxes may be influenced depending on where inventory value lies across COGS and ending inventory balance sheets. Profit is a good thing, but it ultimately increases the amount of taxable net income a business has to report at the end of the year. Reaping larger margins from cheaper inventory first with the FIFO inventory method means owing more. That may or may not be worthwhile, depending on how substantial the difference in new and old inventory value is. 

Expensive units that are sold first with the LIFO inventory system have a higher COGS, which reduces profit margins and taxable income during periods of inflation. The method directly matches current costs with revenue and produces fairer real-time financial modeling data. FIFO only becomes a cost-effective tax strategy when current market prices are higher than those paid for the oldest inventory. 

Risk of Spoilage

FIFO is often used over LIFO to mitigate product spoilage. Perishable goods have a fixed shelf life that stays the same regardless of changes in unit cost. Older inventory is at a greater risk of going bad, so it’s given priority over new inventory with later expiry dates. Businesses that sell lots of Consumer Packaged Goods (CPG) like supplements, cosmetics, and cleaning products should use FIFO to reduce their risk of costly waste. 

Simplicity of Implementation and Management

The FIFO method is widely used because companies often sell products in the order they purchase or manufacture them by default. It's a logical inventory management method that matches the actual physical flow of goods. Accounting for inventory purchases in the order they were made on the balance sheet is also simpler when prices fluctuate often. 

Predictability Over Profit Margins

The FIFO method provides more predictability over net profit because the value of older inventory is already known. Meanwhile, a business using the LIFO inventory valuation model would have less certainty over its profit margins from month to month as current market prices change. The risk of immediate impacts on the bottom line is mitigated by relegating goods with potentially different prices to the ending inventory balance sheet under FIFO.

Manage inventory correctly, and your company can reap cost savings and efficiency that ultimately spur long-term growth. Failure to strategize makes profit an uphill battle. Shipfusion is the trusted source of guidance for decisions big and small for countless businesses. As an industry-leading third-party logistics (3PL) company, we know a thing or two about running efficient operations. 

It starts with control. That’s why our data reporting tracks key metrics in real-time – to give clients the insight they need to make informed decisions. If changes need to be made, dedicated Account Managers are always ready to address concerns on the warehouse floor. Rapidly-expanding companies can further benefit from Shipfusion’s seamless fulfillment solutions, which are designed to scale without compromising attention to detail. 

See how an advanced fulfillment partner can positively affect your net income by reaching out to our team today.