When dealing with stock and inventory valuation, there are three main options: LIFO (Last in First out), FIFO (First in First out) and AVCO (Average Cost or Weighted Cost). When deciding which of these is best for your retail business, it depends on how you would like stock values reflected in your accounting for cost of goods sold and how you deal with inventory.
Choosing the correct inventory valuation method is a crucial step for a business and can have a significant impact on reported profitability. In this article, we'll focus mainly on FIFO vs LIFO and evaluate some strengths and weaknesses of each approach, before finishing up with why Brightpearl takes advantage of FIFO costing...
FIFO (just as the name suggests) is where the first items in are the first items out; meaning the oldest stock is always being sent out first. With FIFO, the cost of goods sold accounted for on a sale is the value of the oldest inventory, and when accounting for stock on sales, you will be using the actual price you paid for the items. This is the most widely used accounting method in periodic stock management. If your costs fluctuate, exercising FIFO can be more complex if you do not have a system in place to help keep track, but it does come with some great advantages, including:
- It’s realistic against what’s happening in your warehouse, given that most businesses ship older stock first to avoid it depreciating in value or spoiling.
- During inflation, FIFO increases the value of your inventory as you continue to purchase (as the inventory you’re buying next is more expensive), as well as net income, because your older items with a lower cost of goods would now be a smaller percentage of your sale price. The results being: higher asset values and reported profitability, and that’s always nice!
- Your operational reports are more accurate. Your balance sheet will reflect the actual costs that you paid to acquire inventory so you don’t have to apply any extra logic to find the exact amount paid to acquire your inventory.
LIFO is the opposite of FIFO in that it accounts for your most recently received stock when you make a sale, even if you have other units that have been on the shelves for years and were purchased at a different price. In the US, a lot of accountants will often advise the use of LIFO as their preferred method when you have stock with frequently changing costs. This is because it helps with the matching of the latest costs of products with the sales revenue of the current period for tax purposes and can be an easier approach to inventory valuations initially. But LIFO can cause you headaches with stock that is too old or out of date and needs shifting, which can cause issues as your business scales. Other disavantages include:
- Keeps taxable income down when your cost prices rise, but you’ll be recording less profit.
- If you plan to expand globally, not all country accounting standards allow a LIFO valuation. For instance, LIFO is permitted under GAAP and prohibited under IFRS.
- LIFO generally makes reporting difficult. If you have high inventory turnover, with prices that rise and fall over time, then your stock valuation won’t represent the prices you actually paid, meaning your procurement and merchandising teams will never know exactly how much money you’ve already got held up in inventory.
AVCO (Average Cost or Weighted Cost)
Unlike FIFO and LIFO, AVCO (Average Cost or Weighted Cost) has no real bearing on which stock is sent out to customers. But instead, it has more of an effect on the accounting as you will be using the average cost price when dealing with the cost of goods. Here, the total cost of goods that are in stock and can be sold, are divided by the sum of the products from the beginning inventory and purchases to give a weighted average of all total unit cost prices. As this is not considered the most accurate way to value your stock, we will continue to focus on FIFO vs LIFO in this article instead.
FIFO vs LIFO Example: Demonstrating the Costs
The chart below shows the differences in how FIFO and LIFO stock valuations are calculated as your items move through the buying cycle. As you will notice, the results differ considerably with LIFO showing you less reported profit at the end:
Whilst LIFO has its place for those wishing to keep taxable income down, FIFO brings the most benefits to a growing retail or wholesale business. Higher reported profitability and asset values can help significantly in the search for investment. Many independent businesses can be put off because of FIFO’s administrative overhead - tracking the full ins and outs of your inventory lines can get messy.
But that’s where software can help!
Brightpearl and its merchants use FIFO. Brightpearl’s a unique solution because we collate all purchasing, sales, and accounting activity under a single system, and can therefore accurately track everything for you. When you raise a purchase order for replenishment, your reports show the true value of your current inventory. When you receive the new inventory, we record its value as per the purchase invoice. When you make a sale, we record its cost as per FIFO. And when you want to look at your company's financials, you know its accurate and available in real time.
When combined with real time accounting, FIFO gives a truer picture of the profitability of your goods and a better view of your income statement over time. LIFO can cause a distorted picture of your profits if you are constantly selling your newest goods (which may be at a massively lower or higher price than the oldest items you have). This is especially important for goods that have a lifecycle, like food, technology and yes, even fashion - these all have a limited lifecycle or shelf life.
Where new and improved products are always around the corner, you do not want to be left with obsolete or hard to move last season goods sitting on your shelves. This will cost you as you will need to reduce your prices to move them. This is never good on your bottom line and for that reason, LIFO is not usually the best option for most retailers.
Because we use FIFO, you can see the true margin on goods sold based on the cost you paid for it, and over time, you can see if that margin is getting better or worse. As we all know, the cost of goods vary, depending on exchange rates, the market, and even the supplier. Being able to see the actual cost you paid for that item is important. Knowing the true cost and moving your oldest stock gives you a more accurate picture on profitability, product costs and in the end, more power to decide where to get your stock from.