10. FIFO and LIFO

Let's take a look at FIFO and LIFO. FIFO and LIFO are inventory costing methods. We've already looked at the other two, and the other two are weighted average and specific identification. Now, FIFO and LIFO stand for first and last, first in, first out, and last in, first out. So it's first in, first out, last in, first out. So let's see if we can figure out what this actually means. Let's look at an inventory purchase schedule. Let's say we start with 20 units of inventory at $4 each for a total of $80. Then we have a purchase of 40 at $5 for $200.

Another purchase of 50 at $6 for $300. And finally, we have another one of 60 at $7 for $420. So in the end, we've got 170 units at $1,000 total. Now, if you'll remember weighted average, that was pretty simple. We just said $1,000 divided by 170 units gives us some dollar per unit. That one is easy. I like that one a lot because it assigns an average unit cost to all of these units. But that's not what we're doing. We're doing first in, first out, and last in, first out.

With this inventory schedule, let's look at two problems, one for FIFO and one for LIFO. So the problem is going to be... Let's see. The problem should be 40. So if we say ending inventory was counted to be 40 units.

Calculate cost of goods sold and ending inventory for FIFO and LIFO. Okay, so let's start with FIFO. We know the ending inventory was 40 units. So let's first figure out how many units there are. I think we added them up, and we said 170. So there are 170 total units. For both problems, there were 40 in ending inventory, which leaves us 130 for cost of goods sold. So we're gonna try to figure out how much this 130 cost and how much this 40 cost. So let's just make a note for ourselves, and do this on the test. Make a note for yourself that cost of goods sold is 130 units 'cause we sold 130 units.

Now we need to figure out the actual price, but the goods available for sale breaks down into what we didn't sell and what we did sell, and this 170 is the goods available for sale. Now, what I think helps a lot here, 'cause we're dealing with first and last, and then first and first, so we need to know where is first and where is last. So I always like to put first up at the top and last down at the bottom because beginning inventory, that's the first inventory we had. Then we made a purchase, made another purchase, made another purchase. So if you think of it, and this is gonna be super nerdy, if you think of it as layers of sediment, right?

The very, very bottom, you have your bedrock. That's your beginning inventory, and then over time, you add on more and more layers of purchases, and you just keep laying sediment down just like that. Each purchase is another layer on top. But the very first layer, the very bottom layer is your beginning inventory. Anytime you can compare accounting to geology, you're doing pretty well. So I feel like this will help you remember. Okay, so like I said, I like to start by putting first up here and last down there, and then you have this arrow that says which direction time flows. So now we know where first is and where last is because this whole concept revolves around first and last.

So if you don't know where first and last are, you're straight out of luck. So now we know we need to split all of these up into a section of 40 units and a section of 130 units. Because the total of these right here is our 170. That's our goods available for sale. And we decided that part of that went to COGS and part of that went to ending inventory, right? So we decided it was 40 and 130 based on the problem. It told us it was 40. So for first in, first out, you start at the top. The first ones we bought are the first ones that we're going to sell.

So these 20, those were the first ones we had. Those were the very beginning, and then we started layering purchases in on top. But before we did anything, we had these 20 right here. So those 20, those are the first to go, and then what we do is we work our way first in, first out. So the first ones we bought are the first ones to go, and now what we're trying to do is we're trying to cover the 130. We're trying to add up to 130 that we actually sold, so that we're left at the end with 40 that we didn't sell.

So what we're gonna do is we're just gonna start at the top and keep going until we hit 130. So 20. So we sold 20 at $4 for $80. Well, 20 is not 130. 40, that makes 60. That's not enough. 50, that makes 110. That's not enough. But then if we add in 60, we're at 170. So what we need to do is split this one up. So instead of saying 60 at $7, why don't we say 20 at $7 and 40 at $7? You see how we didn't really actually change anything? 20 at $7 plus 40 at $7 is, well, that's 60 at $7.

But now you can see what we're left with. We're left with 130 and 40. So we're left with cost of goods sold and ending inventory. And the reason I had to make this artificial split right here is because the number that we were trying to get to was 130, and these didn't add up to 130. So I needed to borrow 20 from this last purchase. So I started here, worked my way all the way up, and then stopped halfway through this purchase layer. So what I did was I just artificially split this purchase layer and said, "Okay, now this whole thing becomes cost of goods sold, and then the rest of this becomes the ending inventory."

So I took this one purchase layer and just split it, because it's the same thing to say 20 at $7 plus 40 at $7 as it is to say 60 at $7. I wanna walk you back through this, just to make sure you understand completely what it is we're doing. We read the problem, and we said ending inventory is 40 units, and we knew that there were 170 units available for sale, 'cause we added 20, 40, 50, and 60. We added all that up, and we got 170. So we came over here, and we said, "Well, if there are 170 units and 40 of them are left over, then that means we sold 130 of them."

40 go to ending inventory. The rest go to cost of goods sold. So now what we can do for FIFO, FIFO is the first ones in are the first ones to go. So we start at the top. We say beginning inventory is definitely the first. That's the first layer, and then we layer purchases in on top of that. So we start at the top where the first ones are, and we work our way down. We burn down until we hit 130. Once we hit 130, boom, we stop. 130 is the cost of goods sold, and then this leftover 40 is the ending inventory.

And we worked our way through a bunch of purchase layers until we got to one purchase layer that we had to split and say, "Okay, I'll split this one up into 20 and 40," even though this whole layer was 60.

So then the question says, "Calculate COGS and ending inventory." So what you have to do is you say, "Okay, 20 at $4, 40 at $5, 50 at $6, and now 20 at $7." So that's $200, that's $300, and that's $140. So that's $500, that's $640, that's $720. So the value of our cost of goods sold is $720. Now, I'm gonna guess the ending inventory is $280. Let's see if that's right. 40 at $7 equals $280. 40 times 7 is 280. And how did I guess?

Well, I knew that the goods available for sale equaled $1,000. So if we say that goods available for sale is made up of cost of goods sold, well, then obviously the other one is $280. Now, let's have some fun and do it all again, but for LIFO. So let me clean some of this up. Let's put this back together. We took that apart and made it 40 and 20. I'm gonna put it back together and just make it 60. Let's get rid of this guy.

Okay, so now we're gonna do it for LIFO. We just did it for FIFO, and you'll find that LIFO is not much different. The only difference is the direction in which you go. So we still have 40 units. We still have 130 units. So we still have the 40 plus 130 equals 170, goods available for sale, uh, cost of goods sold, and ending inventory. So that hasn't changed. These are still our unit values. What has changed is instead of starting at the top and burning through all these purchases, we're gonna start at the bottom and try to burn our way back to beginning inventory.

And the reason we start at the bottom is because now the last ones that came in are the first ones to go. So we purchased these last, right? This was the last layer to go on, which means now since we're doing LIFO, this top layer, that's the first one to go. And if we get all the way through that, then this layer, that's the next one to go, because we're going from the last back up towards the first. So now we're going this direction. We need to cover 130 units to get to our cost of goods sold. So let's start here.

60, that's not enough. Plus 50, that's 110. Plus 40, that's 150. So we've gone too far. So 110 plus 40 was too much, so we can't take this entire layer because that's too much. But what if it was 20? That gives us the 130 we need. So just like we did in FIFO, we're gonna split this layer into two layers. So instead of 40 at $5, we're gonna say, "Okay, 40 is also known as 20 plus 20." So I can split that layer, and it doesn't really make a difference. Now, if you look closely, we've got 130 cost of goods sold, and we've got 40 ending inventory.

And so this time we started up here, and we worked our way down, and somewhere in here we had to split a different layer into 20 and 20, which was originally a 40 layer. So now under LIFO, we've got 20 at $4 for $80.

I'm gonna find some room here. We've got 20 at $4 for $80 and 20 at $5. That makes $100. So the total ending inventory is $180. You can see it's different, and that's kinda the whole point. It's different than when you do it under FIFO.

So we could calculate it, or we can just guess and say, "Well, it's gonna be $720," 'cause $180 plus $720 equals $1,000. Let's see if we're right. We've got 20 at $5 for $100. 50 at $6 for $300. 60 at $7 for $420.

And it turns out to be $820, because my mental math is terrible. So lesson learned, don't do mental math. So $180 plus $820 actually equals $1,000. That was just to test you. So then one of the things that your teachers are gonna love to ask is, "What's the advantage of LIFO?" Or, "What's the advantage of FIFO?" Let's see if we can figure that out. Um, okay, so we've got FIFO ending inventory of $280, LIFO ending inventory of $180. Let's see if we can find some room. LIFO, FIFO, ending inventory, COGS.

And it was $280 for FIFO, $180 for LIFO. $820, $720. And you can see that we get some relatively different numbers despite having the exact same purchase schedule. So even though we had the exact same purchase schedule that we were working with for both problems, this was the same. This was totally the same. Nothing changed. Just based on our inventory costing method, we ended up with a $100 difference in ending inventory and cost of goods sold. So why can that be good, or why can that be bad?

Where does cost of goods sold go? Well, cost of goods sold is an expense, and expenses go into net income, right? So if we have a higher expense, we have a lower net income. So on LIFO, we ended up with a smaller net income, and on FIFO, we ended up with a higher net income because we had a smaller expense, which gave us a bigger net income, and we had a bigger expense, which gave us a smaller net income. We also, under LIFO, we ended up with a smaller ending inventory. And inventory is an asset, so we ended up with lower assets, whereas with FIFO we ended up with higher assets.

Now, you may look at this and go, "Well, FIFO gives you a bigger net income and bigger assets. Why would anyone ever choose LIFO?" Well, bigger net income also means more taxes, doesn't it? Don't you pay taxes on your net income? So a smaller net income actually leads to smaller taxes.

So it's kinda tricky because it really depends on what you're optimizing for. Because if you're optimizing for, let's say, investment, you may want a high net income because you may wanna show your investors, "Hey, we make a lot of money." If you're optimizing for a bank loan, you may want higher assets to say, "Look, we have a lot of assets against which we can collateralize your loan." But if you're trying to reduce your taxes, you want a smaller net income, so you can say to the government, "Oh, we didn't make very much money. We don't have to pay very much taxes." So when the question says, what are the advantages of LIFO?

What are the advantages of FIFO? The answer truly is, it depends. Now on your test, you're gonna see "during a period of rising prices," and that's what you see here. When you first started, it cost you $4, then it cost you $5, then $6, and finally, when you were done, you were paying $7 a unit. So this is a period of rising prices. So the question will say, during a period of rising prices, if you want to minimize your net income, what should you do? And you just gotta think it through. To minimize net income, if you want revenues minus expenses to be small, you can either decrease revenues or increase expenses.

Well, inventory doesn't say anything about revenues. Inventory is kinda linked to cost of goods sold. So if we can raise cost of goods sold, then we can lower net income, and lowering net income lowers taxes. So you gotta take stuff that you already know and apply it to these questions. And if you see a word problem that says something like that, during a period of rising prices, what would be this case, or what would be the best to do in this scenario? It's not bad to go out in the margin and draw one of these purchase schedules and just kinda, you know, work through it.

You don't have to do all the math, just kinda look at it and go, "Okay, well, if I do LIFO, then oh, look, all the expensive stuff ends up in my cost of goods sold. And if I do FIFO, oh man, all the cheap stuff ends up in my cost of goods sold." So if you see a word problem, go out in the margin and draw a 4, 5, 6, 7 and put, you know, beginning inventory, purchases. These numbers don't really matter 'cause you just need to know which direction you're going to know which portion the expensive items end up in. Do they end up in COGS, or do they end up in ending inventory?