Definition of LIFO
LIFO (which is the acronym for Last In, First Out) is a cost flow assumption in which the most recent costs of inventory items are the first costs to be removed from inventory and reported as the cost of goods sold. As a result, the older costs remain in inventory.
Definition of FIFO
FIFO (which is the acronym for First In, First Out) is a cost flow assumption in which the oldest costs of inventory items are the first costs to be removed from inventory and reported as the cost of goods sold. As a result, the most recent costs remain in inventory.
Definition of Gross Profit
Net sales – Cost of goods sold = gross profit?
Difference between LIFO and FIFO
If there were no changes in the cost of inventory items (purchased or manufactured), there would be no difference between the LIFO and FIFO cost flows.
Since costs have historically increased, the latest or most recent costs are higher than the older costs. When the recent higher costs are removed from inventory and reported as the cost of goods sold on the income statement, the resulting gross profit will be lower. If the corporation ends up with lower taxable income, it likely means lower income tax expense.
Example Comparing LIFO and FIFO
ABC Store purchases a product and then sells them to its retail customers. ABC began on January 2 and purchased 1 unit of product in each of the following months at these costs: $10 in January, $12 in April, $13 in October. Therefore, ABC’s cost of goods available amounted to $35. Next, assume that 2 units were sold and 1 is in inventory on December 31. Also assume that the retail price remained constant at $16 each.
Using the LIFO cost flow assumption, the cost of the 2 units sold will be $25 ($13 + $12)
Using the FIFO cost flow assumption, the cost of the 2 units sold will be $22 ($10 + $12)
Gross profit using LIFO: Sales of $32 – COGS $25 = $7
Gross profit using FIFO: Sales of $32 – COGS $22 = $10
Note that the LIFO gross profit is $3 less than the FIFO gross profit.
