Take-aways:

• LIFO and FIFO refer to accounting methods to assign costs from inventory to cost of sales. The accounting method is independent from the physical flow of inventory. For example, Whole Foods Market, Inc. accounts for its inventory under LIFO, last-in-first-out, but sells the older inventory first before the food spoils (i.e., first-in-first-out physical inventory management method).

• Older LIFO layers have lower unit costs when input prices are increasing and these layers can stay in inventories indefinitely. As a result, LIFO inventories can be valued much lower than they would be at replacement costs.

• Generally, LIFO and FIFO cost of sales and inventory balances differ and thus ratios that depend on them differ. When input prices are rising, LIFO cost of sales exceed FIFO cost of sales, LIFO gross margin is less than FIFO gross margin, and LIFO inventory is less than FIFO inventory.

• Comparing companies’ ratios based on numbers reported under LIFO to those reported under FIFO greatly distort analyses.

Key terms:

• Average cost method-  Accounting method where the unit cost assigned to both inventory and cost of sales is the weighted average cost per unit. Average cost is determined by dividing total cost of inventory by the number of units in inventory. Also called weighted average cost method.

• Cost of sales-  Expenses attributable to sales of goods or services. When a sale is recognized as revenue, cost of sales is recognized as an expense. Also known as cost of goods sold.

• Inventory-  Assets purchased or produced with the intent to sell them to customers as products. Includes materials, parts, other costs, and partially completed products that will end up in products sold to customers.

• LIFO- Last-in-first-out, accounting method where the last costs assigned to inventory are the first assigned to cost of sales.

• LIFO layer- Under LIFO cost method, the quantity of units added to ending inventory when inventory purchases exceed sales. The quantity of inventory when a company starts using LIFO is the “base layer”.  Subsequently, LIFO layers are added during reporting periods when the number of units produced or acquired is more than the units sold.

• LIFO reserve- The difference between inventories valued under FIFO versus LIFO costing methods. A contra asset for the excess of FIFO over LIFO inventory costs.

• FIFO- First-in-first-out, accounting method where the first costs assigned to inventory are the first assigned to cost of sales.
  

Key formula:

• Inventory turnover = cost of sales / average inventories