LIFO Versus FIFO and How Each Method Values Inventory

As the name implies, First-In, First-Out (FIFO) is a way for companies to value their inventory. The first items put into inventory or produced by the company are accordingly the first taken out of inventory or transferred to customers and therefore expensed. When it comes to accounting for acquisition and/or production costs, initial and earlier costs are the first to be expensed, with more recent costs staying on the balance sheet to be expensed later.

Assume a company already has 200 widgets costing $4/widget. From there, the company increased its inventory at three more times during a selected accounting period. Three hypothetical, additional purchases include:

200 widgets @ $6/widget

200 widgets @ $7/widget

200 widgets @ $8/widget

If the company had 500 widgets purchased, there would be different considerations be it FIFO or LIFO. First, we’ll discuss FIFO.

For the 500 widgets sold to customers, the FIFO’s Cost of Goods Sold (COGS) (assuming there are no additional inputs that would increase the COGS for simplicity sake) would be $2,700.

This calculation will look at how COGS works for FIFO:

200 initial widgets costing $4/widget = $800 in COGS  

200 widgets from the first additional purchase, costing $6/widget = $1,200 in COGS

100 widgets from the second additional purchase, costing $7/widget = $700 in COGS

For a total of $2,700 in COGS

Assuming there were no purchases during the selected accounting period, there would be 300 widgets remaining in inventory, or $3,000 in inventory costs. The inventory would show up on the balance sheet, according to the following calculation:

200 widgets @ $7/widget = $1,400 in inventory

200 widgets @ $8/widget = $1,600 in inventory

Now this is compared to LIFO, or Last-In, First-Out, which accounts for expenses by looking at most recent costs first. With the same company selling the same 500 widgets in the same accounting time-frame, but expensing their most recent 500 widgets first, here is the rundown:

200 widgets @ $8/widget = $1,600 in COGS

200 widgets @ $7/widget = $1,400 in COGS

100 widgets @ $6/widget = $600 in COGS

For a total of $3,600 expensed

The inventory would be left as the following:

100 widgets @ $6/widget = $600

200 widgets @ $4/widget = $800

For a total of $1,400 in remaining inventory.

Considerations Between LIFO and FIFO

One important consideration when choosing between LIFO or FIFO is that more likely than not input costs rise over time. Therefore, valuations can change based on the type of method.

Looking at the LIFO method, taking out inventory that’s been produced most recently does not always reflect market prices of the remaining inventory, especially if remaining stock is a few years old. Along with Costs of Goods Sold lowering net income, if older inventory is obsolete and it can’t be sold, it’ll render the inventory’s value far below market prices.

When it comes to the FIFO method, you get a better indication of the remaining inventory’s value. However, using this method increases a business’ net income since remaining inventory can be older and is valued by the Cost of Goods Sold. Similarly, if net income increases, there’s also a good chance of greater tax obligations for the company.

These scenarios account for rising prices. However, if prices are falling, then these scenarios would be reversed.

When Full Costing Accounting Makes Sense

With more than 1.4 million accounting jobs in 2018, according to the Bureau of Labor Statistics, there are many different uses for accountants and their skills. With the need for accuracy and transparency in private and public accounting, one important concept to explore is absorption, or full costing.

Absorption or full costing is an accounting method that is used by businesses to determine the complete cost of producing products or services.

When it comes to calculating the full cost, there are three main categories taken in account:

  1. Direct Costs – How much material, labor, machinery, etc. it costs to produce each product.
  2. Total Amount of Fixed Costs – Examples include monthly rent payments, tax payments, base salaries, etc. These are the types of expenses a company would incur regardless of the level of production.
  3. Total Amount of Variable Costs – If there’s increased demand for a particular product, companies would incur variable costs to meet that demand. Examples would include additional wage payments, increased electricity bills for extended or additional shifts, etc. Unlike a pre-negotiated rate for a lease, paying overtime or for more staff would vary based on changes in production needs.

It’s important to note that with absorption or full costing, regardless of the accounting period, both variable and fixed selling and administrative costs are not included when calculating cost per item. These costs are accounted for in the accounting time, whenever the expenses actually occurred or on an accrual basis.

Along with being GAAP-compliant (following Generally Accepting Accounting Principles) when it comes to absorption or full costing, the direct material costs, labor costs and variable and fixed overhead expenses are factored into the per-product cost to the point of sale. Once sold, the expenses will then be reflected on the Income Statement within the COGS fields (Costs of Good Sold).

Further Considerations and Differences with Variable Costing

The primary difference between full costing and variable costing can be seen when it comes to fixed overhead manufacturing costs.

For the absorption or full costing approach, fixed manufacturing overhead costs are recognized when the product is sold. With the variable costing method, the fixed manufacturing overhead costs are accounted for when the business incurs the expenses for that product (i.e., during production time).

Whether or not produced items are sold or still part of the business’ inventory, the absorption costing approach assigns all expenses to the inventory. This helps companies calculate their net profit more precisely. The approach to determining net profit is especially helpful if a company’s inventory is unsold after the accounting timeframe when production occurred.

When fixed costs such as insurance, salary, advertising and related expenses add up quickly and to great amounts, this is something to keep in mind when determining private performance and public perception for publicly traded companies.

Sources

https://www.bls.gov/ooh/business-and-financial/accountants-and-auditors.htm

 

Payroll Management Tips

When it comes to an employer’s responsibility for non-exempt workers, according to the U.S. Department of Labor, there are many requirements businesses must follow related to payroll. In one example, there are strict regulations on what information employers must document for each non-exempt worker. While there’s no requirement on how the information is recorded, there are three main categories.

Personal details: This should include the employee’s name, complete address, Social Security number, date of birth and gender.

Job details: This must include the worker’s job description and hours clocked in each day and week.

Pay details: The employee’s hourly wage based on straight time, and how employees are compensated – be it hourly, weekly, project or item-based. It should include the number of hours worked each week, per day or per week non-overtime earnings, overtime earnings per work week, and the compensation paid to employee for the pay period. Also included should be the day of the employee’s check, for what time period worked is described, and all deductions or increases to the worker’s wages.

Depending on the type of record, employers have different time requirements for record archival. Payroll records must be maintained for 36 months. Schedules, timecards and deduction records for employee earnings must be held for 24 months and be readily accessible for inspection by the U.S. Department of Labor.

When there is minimal deviation from an employee’s schedule, employers simply have to confirm the employee adhered to the schedule. When there is a large deviation (working fewer or more hours than normally scheduled), the actual number of hours worked should be noted. It doesn’t matter how time is kept for an employee, as long as it’s kept – be it manually written by the worker, a supervisor or HR rep or with a time clock.

Other Documentation

The IRS explains that employers are required to complete Form W-2 to maintain compliance with tip and wage payments. This should be completed and submitted by the end of the calendar year.

Employees who fill out the Form W-4 can mitigate estimated tax liability by specifying how much to have withheld from their compensation by their employer. An employee can claim exemption from federal income tax withholding if she had no income tax liability the prior year and does not expect to pay taxes in the coming year. However, the employer is still required to deduct the FICA tax for that employee.

FICA Tax

Also known as the Federal Insurance Contributions Act (FICA), employers are required to withhold two different types of taxes: Social Security and Medicare. According to the Internal Revenue Service (IRS), employers are responsible to calculate and remit these taxes based upon each employee’s wages.  

For the 2019 tax year, Social Security taxes for employer and employee are both 6.2 percent, or 12.4 percent total. This tax is limited to the first $132,900 in wages. The Medicare withholding rate is 1.45 percent of wages for both employer and employee, totaling 2.9 percent. Unlike Social Security taxes, for Medicare there’s no cap on the employee’s total salary. Additionally, for wages exceeding $200,000 for 2019, only the employee is taxed an additional 0.9 percent, in addition to the 1.45 percent (for a total of 2.35 percent of any wages exceeding $200,000 for the 2019 calendar tax year) for Medicare taxes.

Individual Estimated Taxes

Estimated Taxes are meant to satisfy many forms of taxes, and not just income tax obligations. It also includes the alternative minimum tax (AMT) and self-employment taxes. Whether it’s a single entrepreneur, a business partner or someone with equity in an S corporation, as long as they have $1,000 or greater in tax obligations, they have to pay estimated taxes, generally on a quarterly basis. When it comes to corporations, the threshold for estimated tax payments is $500 when they prepare their taxes.  In additional to taxpayers under the tax liabilities outlined above, estimated taxes are not required for individuals who meet the following: there was no tax owed for the preceding year, the individual was a U.S. citizen or resident for the entire year, and the last tax year was for 12 months. Also note that self-employed workers must pay both the employer and employee portion of the FICA tax.

Much like the evolving landscaping of the U.S. Tax Code, the world of payroll is also subject to ongoing changes that are imperative to maintaining compliance.

Sources:

https://www.dol.gov/whd/regs/compliance/whdfs21.htm

https://www.irs.gov/businesses/small-businesses-self-employed/understanding-employment-taxes

https://www.irs.gov/pub/irs-pdf/p15.pdf

https://www.irs.gov/publications/p505