Pros and Cons of LIFO Inventory Method; An Unbiased View

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Introduction

As of now, the USA is the only adopters of the LIFO (Last-In-First-Out) inventory valuation method, other nations that are following the IFRS (International Financial Reporting Standards) rules set by the IASB (International Accounting Standard Board) has either implemented: –

  1. FIFO (First-In-First-Out) method; or
  2.  The weighted average cost valuation method

The LIFO inventory valuation method has received some bad rep in recent years, even more so when IFRS does not approve of the LIFO valuation method. The strongest case against LIFO is embodied by the Exxon Mobile case which significantly overstates the company’s profit.

However, there exists a coalition (savelifo.org) to preserve the use of LIFO as it is claimed to be the most accurate portrayal of the company’s inventory valuation. In addition, there lies the question of whether both LIFO and FIFO method is either it is just another accounting valuation method, or it is also an effective practice of the physical good’s inventory management system.

Accounting and actual supply chain practices may diverge when it comes to the understanding of LIFO. In this blog post, we will try to have an unbiased view of LIFO and also its actual practice in goods in storage.

Hopefully, we can equip our readers with a holistic view of the subject matter, and present the Pros and Cons of using LIFO as an inventory valuation method and an inventory control method

First Things First about LIFO

Let’s take this opportunity to clear the air. Firstly, LIFO as an inventory valuation method is strictly an accounting matter, it does not mean that if the inventory valuation method used is a LIFO method, or FIFO for that matter, the actual inventory storage and utilization HAS to conform with the LIFO method.

Secondly, LIFO must not be misconstrued with “Liner-In/Free -Out” in logistics, where it is a reference to a mode of freight charge.

The case for the use of LIFO as an inventory storage system is less controversial as compared to LIFO as an inventory valuation method. Nevertheless, we will address both subject matters altogether.

LIFO and FIFO Inventory Valuation

It is best to juxtapose the LIFO and FIFO inventory valuation method to get a clear picture.

To describe LIFO, the last product or inventory to be accounted for will be the first to leave the inventory. This means the company will actualize the most recent material price or cost of goods in the inventory when a sale has been made.

FIFO, in comparison, is where the first product to be recorded in inventory will be the first to leave the inventory. FIFO takes into account the earliest recorded cost of goods in inventory when the sale of goods has been made.

Of course, the average cost valuation method takes the average value of inventory as the costs of goods sold.

The complexity begins to surface when we understand 2 key factors

  1. Cost of goods are subject to fluctuate from time to time
  2. Companies hold inventory for a period of time

Costs of Goods sold varies due to a wide variety of reasons:

  1. Increased fixed cost (Labour wages)
  2. Foreign currency fluctuation which makes global sourcing price differ (USD devaluation increase price of materials imported)
  3. Irregularities in supply of raw material (Cocoa Bean supply affected by bad weather)
  4. Change in material source or vendor (switch of vendors)
  5. Political or Geopolitical instability (Brexit)
  6. Increased variable costs (electricity, water)

This graph here will outline the exact impact of utilizing LIFO, FIFO and Average Cost Inventory Valuation Method.

LIFO vs FIFO vs Average

If your company utilizes the LIFO inventory valuation, your COGS would be at a price of USD 35.

If a company utilizes the FIFO inventory valuation, the COGS would be at USD 10, if an average cost valuation method is used, the COGS will be at USD 18.5

Imagine that if the company has a selling price of USD 40: –

  • Revenue for LIFO = USD 40 – USD 35 = USD 5
  • Revenue for FIFO = USD 40 – USD 10 = USD 30
  • Revenue for average cost = USD 40 – USD 18.5 = USD 21.5

You can see the drastic differences that would surface with a different use of inventory valuation method.

Accounting Treatment of LIFO

It is clear that the inventory valuation method will have an impact on the accounting statements.

In an environment where cost of goods sold is ever increasing, LIFO inventory valuation method will report a lower actualized profit. In similar conditions, FIFO will report a higher actualized profit.

At face value, no company or entity is able to predict the future cost of raw material. Hence the perceived notion that FIFO is a better accounting inventory practice seems far-fetched. Of course, the public’s perception is aided by IFRS’s move to disallow LIFO inventory valuation method.

So Why is LIFO Preferred In the USA?

Well, when you take into account the tax benefits of the accounting system, it becomes evident that the LIFO method is a preferred method of inventory valuation.

Of course, preference towards LIFO method is prefaced with the following condition: –

  1. The Cost of Goods Sold will invariably increase, attributed to the inflation rate.
  2. The unit price for the products sold will have a slower rate of increase than the cost of goods sold.
  3. There is an available deferred tax benefit from an increased cost of goods sold.  

LIFO, FIFO Physical Flow Inventory Management

If there are any key takeaways from this, is the fact that the LIFO and FIFO inventory valuation method does not mean that LIFO and FIFO are used to track the physical flow of the goods in storage.

Whether to use the LIFO method or the FIFO method is a matter of practicality. Certain industries are more suited for the LIFO method, while others are more adept to implement the FIFO method.

One reason for choosing one from the other is the available storage facility. As a rule of thumb, when a storage facility such as a warehouse provides high accessibility to the materials, the more likely that the FIFO method is preferred over the LIFO method.

Nature of Business Dictates Inventory Flow Method

Example 1 – Scrap Metal Business

An example can be made for a scrap metal business. Firstly, storage of scrap metal may not facilitate a detailed track and trace system. Secondly, storage of scrap metal will take up a significant amount of space, therefore accessibility of materials may be limited, and finally, the selling price of metal scrap varies on a daily basis.

For this example, one can maintain either a FIFO/LIFO or even a weight average cost valuation to determine the current inventory value. We opined that all three methods are available, the underlying factors that decides the choice of method boils down to:

  • Which is the best method that provides the closest approximation of the inventory’s market value

If either LIFO, FIFO or average cost valuation is the closest approximation to market value, that particular valuation method is used, as long as the method is used consistently over the years and is approved by local and international accounting standards

On the other hand, the physical flow of inventory is an entirely different story. Storage of scrap metal is complicated, in the sense that there is no uniformity in the cargo size, and it requires a large storage space.

Therefore, in order to have an efficient storage space, scrap metals are usually grouped together, making the LIFO method a preferable method of cargo flow movement.

Example 2 – Supermarket Business

Any business that has an inventory of perishable goods only has one logical way of inventory management, which is the FIFO method.

Imagine a grocery store that practices LIFO method flow for their stock of vegetables, by the time the store owner gets to its old stocks, the vegetables have already rotten.

Warehouse Capacity and arrangement to facilitate FIFO and LIFO

LIFO Warehouse

Warehouses that store inventories that are tracked with the LIFO flow method are less extensive as compared to a FIFO warehouse. In most cases, industries that require LIFO warehouses are those that store cargo in amounts that are difficult to track, hard to batch into numbers to trace, and hard to reposition.

The primary requirement that a LIFO warehouse is less focused upon the level of technology system, but rather the amount of square footage space available. Since we understand that cargos that subscribe to the LIFO flow inventory system are usually heavy, massive or difficult to trace.  

Those commodities are such as Scrap metals, Plastic wastes, Wood Logs, Base Metal Storage such as Aluminium are some examples that would have a better storage efficiency if LIFO inventory flow is used.

FIFO Warehouse

There are several key aspects that has to be in place in order to have a warehouse ready for FIFO inventory flow.

  1. Good track and trace system
  2. Cargo accessibility
  3. Ease of Cargo repositioning

All these requirements renders a FIFO centric warehouse a more capital intensive warehouse as compared to a LIFO warehouse, where the bulk of the cost of warehouse operation lies in the warehouse storage lease.

Pros of LIFO Method

Across the board, the biggest benefit from an accounting standpoint is the tax savings that come from a higher valuation of inventory. As we mentioned before, a higher cost of goods sold will equate to a lower EBITDA, a lower EBITDA will equate to a lower taxable income.

This sort of benefit is more sorted for small-medium enterprise business. Where the business is localized and the shareholder, director, and manager are the same person. We are talking about the everyday businessman. Of course, any form of tax incentive is welcomed.

Tax Benefits of LIFO Pro LIFO

Remember: the LIFO method assumes that the company is selling the most recent stocks and what remains in inventory has a lower inventory value

Whether or not this is the most actual reflection of the inventory value is still up to debate.

It is estimated by savelifo.org that with this inventory valuation alone, the tax savings as compared to an inventory valuation that assumes the lowest inventory value recognized as cost of goods sold will be USD 70 billion dollars.

Switching to the LIFO method used for actual physical flow of inventory. The benefits can be seen as such: –

  1. Reduced warehouse handling cost, the more frequent the inventory is handled the higher the cost.
  2. Reduced turnaround time of inventory flow, lesser resources required to track and trace the physical inventory, either by batch number, RFID, barcode, etc…
  3. Reduce investment in warehouse technologies.

Cons of LIFO Method

As opposed to Small Medium Enterprises, the multinational companies or public listed companies has less incentive to maintain a LIFO inventory valuation. Firstly, the only accounting standard U.S. GAAP recognises LIFO valuation, most multinational companies have an international company footprint.

The fact remains that maintaining multiple accounting methods across countries requires more human resources and therefore costlier to maintain.

Another key factor that discredits the use of LIFO as an inventory valuation method is the way major corporation uses this method to understate the cost of goods sold in order to meet earnings targets and increase the company’s reported revenues.

NICOR INC

NICOR INC CON LIFO

Look no further back than a recent case of 2017, where the SEC filed a case against Nicor, Inc., one of the US’s top natural gas distributor for an alleged case of accounting fraud that revolves around the LIFO valuation method.

Nicor Inc is involved in a case with the SEC by utilizing low price reserves and recognize it as an actual cost of goods sold.

The fact of the matter is, although the last inventory purchased may be at a higher price, the corporation has utilized its low-priced inventories and tagged it as the most recent inventory price.

The corporation failed also failed to disclose to the US GAAP authorities about the effects of LIFO inventory liquidation, which makes the investigation deliberately difficult.

Exxon-Mobil

EXXONMOBILCON LIFO

Even large oil conglomerates such as Exxon-mobile are allegedly misrepresenting its profits with the LIFO valuation method. The trigger point is when the gasoline price was at its highest point in 2006, the company has posted record profits that are the highest in its history.

The underlying question is, why small-medium enterprises are religiously petitioning to maintain the LIFO method as a valuation method, whereas the large, listed companies are using the LIFO method to report higher earnings.

The answer lies with the involved stakeholders. As a public listed company, the investors look to a company’s profitability markers, and higher profitability translates to higher perceived stock value, ergo a higher traded stock price.

On the other hand, the stakeholders of a small-medium enterprise are the business owners, which does not need to appease the general investor with a high earnings report; The business owner’s primary concern is cost reduction. The inherent tax benefit from having a higher cost of goods sold valuation is preferred.

Cons of LIFO Inventory Control Method

As a physical flow method there are also disadvantages of organizing a warehouse with LIFO flow in mind.

Depending on the warehouse’s inventory mix, a warehouse that has multiple stock variations has no reason to maintain a LIFO inventory flow. Particularly if a warehouse has an occupancy rate of 80% for products that comes in various SKUs, packaging, batch number, and storage requirements.

The modern warehouse that we see today is not geared towards the use of the LIFO inventory flow method. In fact, there are not many third-party outsourced warehouses that cater to commodities that require the LIFO physical flow inventory system.

So, unless a company does its inventory storage in-house, and a company has a specific type of inventory that makes LIFO a preferable inventory method such as oil, metal commodities, scrap metal, etc… It is not feasible for a warehouse to approach inventory control with the LIFO method.

Key Takeaway

We need to approach the LIFO method on two fronts: –

  1. LIFO as an inventory valuation method
  2. LIFO as a physical inventory flow method

On top of that, we have to be mindful that no one can accurately predict the price of inventories in the long run. Sure, certain measures can be taken such as purchasing futures, hedging commodities, and vendor price re-evaluations to maintain a more predictable and steadier inventory value.

But in our opinion, when comparing the LIFO, FIFO, and even the weighted average inventory cost valuation method, there is no evidence that one method is better than another.

The only reason why, we believe, that IFRS has disallowed the use of the LIFO valuation method is only because major corporations are using this method to misrepresent its financial reporting.

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