The Fifo and Lifo methods: meaning and differences

A guide to understanding how the two most frequently used methods of goods flow management in warehouses and companies work

The Fifo and Lifo methods are two goods flow management systems that are widely used in warehouses and companies. Both methods are used to keep track of the order in which goods arrive and leave, but the approaches differ in the order in which they are taken into consideration.

In this article, we will explain in detail what Fifo and Lifo are and how they differ.

The Fifo method

Il metodo Fifo, letteralmente First In, First Out (ovvero “primo ad entrare, primo ad uscire”), è un sistema di gestione dei flussi e permette che le merci che entrano per prime nel magazzino siano anche le prime ad essere prese in considerazione per la vendita. Pertanto, le merci che sono state in magazzino più a lungo vengono vendute per prime, ottenendo così una buona rotazione delle scorte. Questo sistema, che tiene conto dell’ordine cronologico di arrivo della merce, è particolarmente indicato per prodotti alimentari e per merci soggette a scadenze, come ad esempio farmaci o cosmetici.

The Fifo method, literally First In, First Out, is a flow management system and allows the goods that enter the warehouse first to be also the first to be considered for sale. Therefore, the goods that have been in the warehouse the longest are sold first, thus achieving good stock rotation. This system, which takes into account the chronological order of arrival of goods, is particularly suitable for foodstuffs and goods subject to expiry dates, such as medicines or cosmetics.

Advantages and disadvantages of the Fifo method

The advantages and disadvantages of the Fifo method include:

Advantages

• Assesses inventory accurately. This method accurately evaluates the costs of the goods sold and the remaining stock.
• Avoids expiry of goods. Goods are sold in a chronological order, so the oldest goods are sold first and the risk of goods expiring is avoided.
• Reduces losses. Due to this method, the oldest goods are used first, thus avoiding the risk of unsold goods.

 

Disadvantages

• Increases the cost of goods. The cost of goods sold is calculated on the basis of the cost of the oldest goods, which may be higher than the cost of the newest goods.
• May cause a distortion of results. The Fifo method could lead to a distortion of results in case of fluctuations in the price of goods.
• It has a medium to high management difficulty. In order to avoid errors in the valuation of goods, this method requires very careful management of inventories and stock movements.

 

The Lifo method

The Lifo method, literally Last In, First Out, in contrast to the Fifo method, holds that the goods that enter the warehouse last are then the first to be considered for sale. This method can be advantageous when product prices tend to decrease over time, as the cost of goods remaining in the warehouse will be priced lower, which will have a positive impact on the company’s profits. The system is particularly suitable for clothes or electronic products, which have a value that decreases rapidly over time.

Advantages and disadvantages of the Lifo method

The advantages and disadvantages of the Lifo method include:

Advantages

• It allows a reduction in taxation. This method can reduce the company’s taxable income and consequently the taxes to be paid.
• It has an effective correspondence between cost and revenue. The Lifo system more accurately reflects the trend in the cost of goods over time, since the latest is always the one with the highest cost (due to inflation or price changes).

Disadvantages

• The value of inventories is distorted. This happens because, with the Lifo method, goods remain in stock for a long time, resulting in a loss of value.
• It has a high accounting complexity. The constant monitoring of inventories and costs can create accounting complexity for the company, especially when there are a lot of movements.
• It is not available for all types of business. In the case of businesses that offer services and do not have a stock of goods, the Lifo method may not be applicable.

 

What are the main differences between Fifo and Lifo?

Both the Fifo and the Lifo method can have a significant effect on the valuation of inventory and the determination of the cost of goods sold.

In general, the Fifo method tends to increase the inventory value and reduce the cost of goods sold, while the Lifo method tends to have the opposite effect. Therefore, it is essential to choose the method best suited to the company’s needs and keep it constant over time to ensure proper management of goods.

Examples of calculation of the Fifo and Lifo methods

A practical calculation example is the best way to understand the meaning and differences between the two methods.

Let us assume that a company purchases:

• Lot A on 01/01/2023: 200 pieces at EUR 2 each;
• Lot B on 01/02/2023: 200 pieces at EUR 3 each;
• Lot C on 01/03/2023: 200 pieces at 4 euros each.

Out of a total of 600 pieces, it is assumed that 400 pieces were sold. The stock is therefore reduced to 200 pieces.

Is it possible to determine the value of the remaining pieces, taking into account the various costs incurred by the company?

Using the Fifo method, the remainder is valued with the prices of the lots that arrived last, in this case 4 euros.

Inventory value = 4 x 200 = 800 euros

Using the Lifo method, on the other hand, the remainder is valued with the oldest prices, those of the first purchases of the year, in this case 2 euros.

Inventory value = 2 x 200 = 400 euros

 

In this particular case, prices have trended upwards over time, so the Lifo method leads to an underestimation of inventories. The Fifo method, on the other hand, leads to an inventory calculation closer to the last costs.

 

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