Many businesses buy products they sell later to consumers, hopefully at a profit. Sometimes it will buy the same product at different prices and in different quantities. This creates an interesting scenario for the business and a challenge for the accountant.
Suppose Sally Inc. nuts and bolts it sells to its customers. There is really no good way to tell how many its sells, but it must somehow decide which nuts and bolts it sold. Did it sell the ones it bought first or did it sell the ones it bought last? Who’s to tell. However, Sally Inc. must develop a way of costing its inventory so it can properly report its income to the government.
Two common ways to cost inventory are the LIFO and FIFO method of inventory valuation. FIFO stands for “first in, first out” and LIFO stands for “last in, last out.” FIFO assumes that the first inventory you buy is the first you sell and LIFO assumes the last inventory you buy is the first you sell. Let’s see these two in action.
Sally Inc. sells five television all year and bought ten in all at the following prices:
2 televisions purchased in January for $200 each
2 televisions purchased in March for $210 each
3 televisions purchased in May for $190 each
3 televisions purchased in July for $220 each
Here’s how the LIFO and FIFO methods would account for the five televisions sold:
LIFO FIFO
3 @ $220 each 2 @ $200 each
2 @ $190 each 2 @ $210 each
1 @ $190
LIFO would cost this inventory sold at $1,280 (3*200 + 2*190) and FIFO would cost it at $1,000 (2*200+2*210+1*190). See the calculations the the difference in costing methods?
The number you come up with for the cost of your inventory sold is important because your income tax reported to the government depends on your net income. Your net income is arrived at by subtracting your costs from your total sales. So if your total costs go up, your income goes down and your taxes to the government go down!
However, if your expenses are too high, then your business will not look as profitable, especially if you are looking for someone to buy your business or trying to satisfy stockholders. That’s why it is important to choose your method of costing your inventory sold.