The Basics and Benefits of Inventory Accounting

Categories: Small Business
18 November 2015

From the point of view of a business owner or operator, inventory accounting and valuation provides a great and potentially frightening challenge. To varying degrees, how well these tasks are handled will be reflected in the functionality and sustainability of your business. At the very least, good accounting and valuation practices are required in order to survive the business landscape. The accounting methods you use and how well they are implemented will provide the backbone of your business and give you valuable insights into the overall performance and health of your company.

Two of the most common techniques used by businesses for inventory accounting and valuation are First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). Let’s take a closer look at the most popular one, FIFO, and assess what benefits it can provide for your business.

What is inventory accounting?

First-In, First-Out is an accounting and inventory valuation technique that operates as though the oldest items of inventory are sold first and the newest are sold last or held as inventory. Put simply, FIFO assigns the oldest inventory costs to the most recent sales. While it is particularly useful for businesses who operate with perishable items, it is widely used by a variety of businesses and industries.

As an accounting technique, FIFO operates as a cost assumption method. It assumes that the oldest stock is sold first even if that isn’t technically the case. When used operationally, it provides some obvious practical benefits. For example a supermarket or grocery store, whose inventory is made up of mostly perishable items, will find that FIFO offers the best method of inventory control and valuation. Unlike LIFO, this method tends to more accurately align with the actual flow of goods. This is a plus for most businesses as it creates a truer picture of inventory costs and overall business health.

The Benefits of First In First Out Inventory Accounting?

The most widely used method

One thing that immediately stands out is FIFO’s global acceptance and use. Unlike LIFO it is in line with the International Financial Reporting Standards so poses no problem internationally. While LIFO is mainly used by businesses in the US, and is reported to be on the decline, FIFO is the most used method worldwide.

Simple and logical

As the cycle and flow of goods under FIFO runs logically oldest to newest, it is reasonably easy to use for most businesses. The cost flow layers involved are also simpler than LIFO, making it a stable and user-friendly accounting method. Another plus is that financial and income statements are harder to manipulate under the FIFO method.

Matching inventory costs to the current market value

Because FIFO accounts for the sale of the oldest stock first, the value of on-hand inventory is determined using the most recently acquired items. This provides a more accurate match of inventory cost to current market value and gives a truer idea of inventory value and replacement costs.

Generating a higher gross profit   

One of the trade-offs between FIFO and LIFO is gross profit versus potential tax liability. While LIFO will generally enable a lower tax liability, FIFO fosters a higher gross income as the cost of goods sold (COGS) is usually lower. This is good news for current and potential investors and is arguably a more accurate picture of business profitability and growth.

Matching costs to inflation

As your newest stock is sold last, there is more opportunity to match inventory costs to inflation. Recently acquired stock can be sold at a level that better reflects market value so your business can effectively keep pace, absorbing the worst effects of inflation.

Less chance of obsolete and spoiled stock

Businesses using FIFO as an inventory management technique are able to minimise losses caused by obsolete and perishable stock. With the oldest stock sold first it becomes easier to create a more intuitive flow of goods.

Tried and true?

While the most popular isn’t always the best, FIFO offers a simple and solid solution for all inventory-centred businesses. FIFO definitely stands out as the tried-and-true inventory accounting method.