FIFO or LIFO: Which Is Right for Your Business?

The way businesses value inventory can affect their taxes. It also affects the financial statements companies present to banks when they apply for loans. Businesses generally are allowed to use one method for their taxes and another for their financial statements. Although this can get complicated, choosing the best option for your business may allow you to achieve different business goals.

Cost of Goods Sold

Inventory is not directly taxable unless it's sold. Its value, however, is taxable because it is considered to be part of your company's net profit. Put another way, the inventory in your warehouse isn't taxed while it is there, but the cost of buying and selling it is part of the calculation of the cost of goods sold and reported as part of your company's taxable profit.

The cost of goods sold is calculated using this formula:

Cost of goods sold = starting inventory + purchases/additions – ending inventory + nondeductible items for personal use

That means your company needs to keep careful track of the number of items you buy and sell during your tax year as well as your ending inventory.

Although there are other ways to calculate the cost of goods sold, most businesses use either the first-in-first-out (FIFO) or last-in-first-out (LIFO) method of accounting to value their inventory. FIFO means the items purchased first are sold first. It is the exact opposite of LIFO (last-in-first-out), which means the last items purchased are the first sold. FIFO is the most commonly used method in the United States, but that doesn't mean it's the best choice for your business.

If you expect the cost of your products to go up over time, for example, your taxes may be lower if you use LIFO, but you may have a harder time getting a bank loan because of the way inventory is shown on your financial statements.

Pros and Cons of the Methods

Both systems have pros and cons. To decide which method to use, consider the following:

Inventory plays an important role in your business's overall financial picture. Contact us today for help deciding on the best inventory valuation method for your company.

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