### Robinhood Beats Q3 Estimates, Stock Gains

Do you routinely analyze your companies, but don’t look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets. As a result, inventory is a critical component of the balance sheet. Therefore, it is important that serious investors understand how to assess the inventory line item when comparing companies across industries or in their own portfolios.

### Key Takeaways

• The Last-In, First-Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first.
• The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.
• LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock.
• FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.
• Deciding between these two inventory methods as implications on a company’s financial statements as this decision impacts the value of inventory, cost of goods sold, and net profit.

## What Is Inventory?

Inventory refers to a company’s goods in three stages of production:

• Raw materials are basic goods used to be produced to generate finished products.
• Work-in-progress is items being manufactured but not yet complete.
• Finished inventory are items ready for sale that can be bought and delivered to consumers.

You can take the goods that the company has in the beginning of any given period, add the materials that it purchased to make more goods, subtract the goods that the company sold, cost of goods sold (COGS), and the result is the company’s ending inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets, as inventory can be sold, thus turning it into cash in the near future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

BI

+

Net Purchases

COGS

=

EI

where:

BI = Beginning inventory

EI = Ending Inventory

begin{aligned} &text{BI} + text{ Net Purchases } – text{COGS} = text{EI} &textbf{where:} &text{BI = Beginning inventory} &text{EI = Ending Inventory} end{aligned}

BI+ Net Purchases COGS=EIwhere:BI = Beginning inventoryEI = Ending Inventory

## Understanding LIFO and FIFO

The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost. These methods are used to track the movement of inventory and record appropriate and relevant costs. The concept of LIFO and FIFO exists because a company must determine how to record the movement of its inventory. The amount a company pays for raw materials, labor, and overhead costs is continually changing. For this reason, the amount it cost to make or buy a good today might have been different than one week ago.

The LIFO and FIFO methods simply identify which item is sold first. Consider a company that spends $100 for an inventory item, then spends$150 on a second unit of the same inventory one week later. If the company sells one unit, should it record its cost of goods sold as $100 or$150?

It is up to the company to decide, though there are parameters based on the accounting method the company uses. In addition, companies often try to match the physical movement of inventory to the inventory method they use. The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows.

### First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory–or the oldest inventory–is the sold first. For example, let’s say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at$1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The$1.25 loaves would be allocated to ending inventory (on the balance sheet).

### Last-In, First-Out (LIFO)

The Last-In, First-Out (LIFO) method assumes that the last or moreunit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining$1 loaves would be used to calculate the value of inventory at the end of the period.

### Below are the Ending Inventory Valuations:

• Ending Inventory per LIFO: 1,000 units x $8 =$8,000. Remember that the last units in (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
• Ending Inventory per FIFO: 1,000 units x $15 each =$15,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
• Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)] / 4000 units = $11.25 per unit; 1,000 units X$11.25 each = $11,250. Remember that we take a weighted average of all the units in inventory. ## LIFO or FIFO: It Really Does Matter The difference between$8,000, $15,000 and$11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics—factors that expose a company’s current financial health, and which enable us to make projections about its future, for example. So, which inventory figure a company starts with when valuing its inventory really does matter. And companies are required by law to state which accounting method they used in their published financials.

Although the ABC Company example above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO, or average cost can be complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage, can prevent a company from operating efficiently. For investors, inventory can be one of the most important items to analyze because it can provide insight into what’s happening with a company’s core business.

### Major Differences – LIFO and FIFO (During Inflationary Periods)

LIFO

• The newest inventory item is the first item to be sold.

• Net income is often lower.

• Cost of goods sold is often higher.

• Ending inventory on the balance sheet is often lower.

• LIFO often does not represent the actual movement of inventory (as companies try to sell the items at the most risk of obsolescence).

FIFO

• The oldest inventory item is the first to be sold.

• Net income is often higher.

• Cost of goods sold is often lower.

• Ending inventory on the balance sheet is often higher.

• FIFO more closely represents the actual movement of inventory (as companies try to sell the items at the most risk of obsolescence).

## Is FIFO a Better Inventory Method Than LIFO?

FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this results in higher tax liabilities and potentially higher future write-offs if that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory.

## Does IFRS Permit LIFO?

No, the LIFO inventory method is not permitted under International Financial Reporting Standards (IFRS). Both the LIFO and FIFO methods are permitted under Generally Accepted Accounting Principles (GAAP).

## What Types of Companies Often Use LIFO?

Companies often use LIFO when attempting to reduce its tax liability. LIFO usually doesn’t match the physical movement of inventory, as companies may be more likely to try to move older inventory first. However, companies like car dealerships or gas/oil companies may try to sell items marked with the highest cost to reduce their taxable income.

## What Types of Companies Often Use FIFO?

Companies with perishable goods or items heavily subject to obsolescence are more likely to use LIFO. For example, consider a grocer selling produce. Logistically, that grocery store is more likely to try to sell slightly older bananas as opposed to the most recently delivered. Should the company sell the most recent perishable good it receives, the oldest inventory items will likely go bad.

In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. For example, a chip manufacturer may want to ensure older units of a specific model are moved out of inventory while more recently manufacturer units of the same model may be able to better withhold storage conditions.

## The Bottom Line

Companies have their choice between several different accounting inventory methods, though there are restrictions regarding IFRS. Two of these options are LIFO and FIFO. Companies that opt for the LIFO method sell the most recent inventory times which usually cost more to obtain or manufacture, while the FIFO method results in a lower cost of goods sold and higher inventory. A company’s taxable income, net income, and balance sheet balances will all vary based on the inventory method selected.