What Happens to Net Income and Taxes Under Lifo if Costs Are Continually Rising
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How to Calculate FIFO and LIFO
June 16, 2022
To calculate FIFO (First-In, First Out) determine the cost of your oldest inventory and multiply that cost by the amount of inventory sold, whereas to calculate LIFO (Last-in, First-Out) determine the cost of your most recent inventory and multiply it by the amount of inventory sold.
The FIFO ("First-In, First-Out") method means that the cost of a company's oldest inventory is used in the COGS (Cost of Goods Sold) calculation. LIFO ("Last-In, First-Out") means that the cost of a company's most recent inventory is used instead.
Here's What We'll Cover:
What Is FIFO?
How Do You Calculate FIFO?
What Is LIFO?
How Do You Calculate LIFO?
What Is a FIFO and LIFO Example?
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Is FIFO?
FIFO is an acronym. It stands for "First-In, First-Out" and is used for cost flow assumption purposes. Cost flow assumptions refers to the method of moving the cost of a company's product out of its inventory to its cost of goods sold.
Inventory refers to:
- The cost of purchased goods with the intention of reselling
- The cost of produced goods (including labor, material & manufacturing overhead costs)
The FIFO method goes on the assumption that the older units in a company's inventory have been sold first. Therefore, when calculating COGS (Cost of Goods Sold), the company will go by those specific inventory costs. Although the oldest inventory may not always be the first sold, the FIFO method is not actually linked to the tracking of physical inventory, just inventory totals. However, FIFO makes this assumption in order for the COGS calculation to work.
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.
Please note: If the price paid for the inventory fluctuates during the specific time period you are calculating COGS for, that must be taken into account too.
Let's use an example. Let's say 100 items cost a company $50.00 each to produce. For the next batch of 100, the price went up to $55.00.
Now company management wants to see the cost of goods sold. To date, 105 of the company's product have been purchased. Using the FIFO method, they would look at how much each item cost them to produce. Since only 100 items cost them $50.00, the remaining 5 will have to use the higher $55.00 cost number in order to achieve an accurate total.
See "What Is a FIFO and LIFO Example" below.
What Is LIFO?
LIFO stands for "Last-In, First-Out".
LIFO is the opposite of the FIFO method and it assumes that the most recent items added to a company's inventory are sold first. The company will go by those inventory costs in the COGS (Cost of Goods Sold) calculation.
The LIFO method for financial accounting may be used over FIFO when the cost of inventory is increasing, perhaps due to inflation. Using FIFO means the cost of a sale will be higher because the more expensive items in inventory are being sold off first. As well, the taxes a company will pay will be cheaper because they will be making less profit. Over an extended period, these savings can be significant for a business.
The LIFO method is only legal in the United States.
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.
What Is a FIFO and LIFO Example?
Here is an example of a small business using the FIFO and LIFO methods.
FIFO
Lee's Lighting buys and resells lamps. Here's a look at what it's been costing Lee 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 |
Let's say on January 1st of the new year, Lee 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 Lee is going by the FIFO method, he is using the oldest cost of $50.00 per lamp in the calculation.)
LIFO
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 Lee will get a tax break. The 220 lamps Lee 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.
More Resources on Small Business Accounting
| Straight Line Depreciation | Income Statement | Business Expenses |
| Debit vs Credit | How To Calculate Total Assets | Business Expense Categories |
| COGS | Net Operating Loss | What is a write-off? |
| Break Even Point Formula | Retained Earnings Formula | Gross Profit Margin Formula |
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Source: https://www.freshbooks.com/hub/accounting/calculate-fifo-and-lifo
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