How to Calculate Gross Profit Using FIFO
It’s the time of the year when you must know your costs to calculate your profits and submit your information to the IRS.
So how do you calculate your costs? How do you calculate your gross profit? Should you be using the FIFO method (First In First Out) or should you be using the LIFO method (Last In Last Out) or should you be using other methods of inventory valuation?
That’s what we’ll be discussing in this article.
Inventory Valuation Methods:
There are four methods for inventory valuation: FIFO, LIFO, Average Cost Valuation, and Specific Inventory Tracing. Here’s a brief overview of each method:
- FIFO (First In, First Out): This method assumes that the oldest inventory items are sold first. The cost of the oldest items is used to determine the cost of goods sold, which may be lower than the cost of more recent purchases.
- LIFO (Last In, First Out): Contrary to FIFO, LIFO assumes that the most recently acquired items are sold first. This means the cost of the newer items is used to calculate the cost of goods sold, which can be higher if prices are rising, thus reducing taxable income.
- Average Cost Valuation: This method calculates the cost of goods sold based on the average cost of all items in inventory, irrespective of purchase dates. It smooths out price fluctuations because every item has the same cost.
- Specific Inventory Tracing: This approach tracks each item individually throughout the inventory system. It is typically used for large, costly, or unique items where specific identification of each item is possible.
Inventory valuation methods are essential for accounting and financial reporting, as they affect the cost of goods sold and the ending inventory balance, which in turn affects net income and tax liability. The choice of method can depend on various factors, including the type of inventory, the industry standard, and tax considerations.
How to Calculate Gross Profit Using FIFO
FIFO is an inventory valuation method where it is assumed that the oldest items in a company’s inventory are sold first. The cost associated with these older items is used when calculating the Cost of Goods Sold (COGS) on the income statement. FIFO is primarily used for cost flow assumption purposes, which means it’s a way to simulate the flow of inventory costs in a company’s financials.
Using FIFO can have significant implications for a company’s financial statements, especially in times of inflation. Since older inventory is usually cheaper than newer inventory when prices are rising, FIFO will result in lower COGS and, therefore, a higher gross profit compared to other methods like LIFO (Last In, First Out).
- To calculate FIFO, you follow these steps:
- Determine the cost of your oldest inventory: Identify the cost of inventory that was purchased or produced first. This will be the cost used in the COGS calculation.
- Multiply that cost by the amount of inventory sold: Take the cost determined in the first step and multiply it by the number of units sold. This gives you the COGS. The remaining inventory is valued at the most recent costs.
- Suppose a company has the following inventory purchases:
- 100 units at $10 (oldest)
- 200 units at $15
- 300 units at $20 (most recent)
- If the company sells 250 units, under FIFO, the COGS would be calculated as follows:
- The first 100 units sold are valued at $10 (the oldest price), so 100 x $10 = $1,000.
- The next 150 units are taken from the next oldest batch, valued at $15, so 150 x $15 = $2,250.
- The total COGS would be $1,000 + $2,250 = $3,250.
- The ending inventory would be the remaining items valued at the most recent costs, so 50 units from the $15 batch and all 300 units from the $20 batch.
FIFO is a popular method because it is straightforward and aligns with the actual physical flow of goods in many businesses. However, the choice of inventory valuation method can affect tax liability and profitability, so companies often choose the method that best matches their financial strategy and reporting requirements.
Calculating Gross Profit Using LIFO
LIFO is an inventory valuation method that assumes the most recent items added to a company’s inventory are the ones sold first. This is in contrast to FIFO, which assumes the oldest items are sold first. The LIFO method is predominantly used in the United States.
The LIFO method is unique in that it is only legal for financial reporting in the United States. Other countries do not allow it for financial reporting under the International Financial Reporting Standards (IFRS).
- To calculate the cost of goods sold (COGS) under LIFO, follow these steps:
- Determine the cost of your most recent inventory: Look at the most recent purchases or productions and use that cost as the basis for COGS.
- Multiply that cost by the amount of inventory sold: Take the cost of the most recent inventory and multiply it by the number of units sold to determine COGS.
Using LIFO can affect a company’s profitability and taxes:
- In periods of rising prices, LIFO will result in higher COGS on the income statement because the newer, more expensive inventory is sold first. This reduces reported net income.
- A lower net income means the company will have a lower tax liability, which is often considered a tax break.
The LIFO reserve is the difference between the inventory reported under LIFO and what it would have been using FIFO. This reserve represents the amount by which a company’s taxable income has been deferred by using the LIFO method. For example, if the difference between the LIFO and FIFO valuation of inventory is $4,000, this amount is the LIFO reserve. The reserve is important because it allows users of financial statements to compare inventory costs calculated under LIFO to those under FIFO.
In practice, LIFO tends to lower current tax expenses, but it also results in lower reported earnings since the cost of more expensive, recent inventory items is recognized first. Over time, this can lead to a significant LIFO reserve, which is a liability that would have to be accounted for if the company ever switched to another inventory valuation method or if LIFO was disallowed by tax regulations.
Choosing a Cost Accounting Method:
Choosing a cost accounting method is a significant decision for a company as it can impact financial statements, tax liability, and business strategy. The decision should be made with consideration of several factors:
Companies should consider the type of inventory they hold. If inventory items are not interchangeable, like cars with different features, Specific Identification might be appropriate. For commodities or homogeneous goods, methods like FIFO, LIFO, or Average Cost are more suitable.
If the prices of inventory items fluctuate widely, the choice of accounting method can significantly affect the cost of goods sold and ending inventory values. In inflationary times, FIFO will report higher profits, whereas LIFO will typically result in lower taxable income.
LIFO can result in lower taxable income because it assumes the most recent and often more expensive inventory is sold first. However, this method is only allowed in the U.S. FIFO, conversely, may lead to higher taxes but can be more straightforward for international companies.
Some industries tend to favor one method over others due to the nature of the costs involved or traditional practices. It’s often beneficial to align with industry standards unless there’s a compelling reason to deviate.
Companies aiming to present higher profits in their financial statements may lean towards FIFO during periods of rising prices. Conversely, companies looking to reduce profits to manage tax liabilities may prefer LIFO.
The choice may also depend on the actual flow of goods. If a company’s physical inventory system operates on a FIFO basis, it might be simpler and more transparent to use the same method for cost accounting.
Management must also consider the long-term effects of each method. LIFO can lead to a LIFO reserve that may become a liability if the company discontinues LIFO. FIFO is less likely to lead to such discrepancies over time.
It’s critical to ensure the chosen method is compliant with the accounting standards applicable to the company, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
Each method has its advantages and disadvantages, and the choice depends on the company’s specific circumstances. Companies often consult with financial advisors or accountants to make the most informed decision.