When an order comes in, which stock do you use to fill the order? Do you pull from your oldest stock first (FIFO – first-in-first-out) or your newest inventory arrivals (LIFO – last-in-first-out)?
Inventory planning is something you have to get right as an omnichannel e-commerce seller. While your warehousing workflows and inventory counts need to be reliable and accurate to ensure maximum logistical efficiency, these practices also play a major role in your cost accounting.
The way in which you select stock to use to fulfill orders has a direct effect on your inventory valuation. As a result, the method that you choose will also have a major impact on your e-commerce business come tax time.
So, which style of inventory valuation is better? As with most things in the e-commerce industry, the answer is, “it depends.” There are a number of factors that go into making the optimal choice between FIFO and LIFO for your brand and business. Some of the most common reasons for choosing one over the other are:
- Product type
- Inflationary conditions
- Market values
- Tax implications
In some cases, one style of inventory valuation model may be the optimal choice for your brand forever. In others, you may find yourself shifting between the two approaches depending upon financial and market conditions.
That said, there are regulations and procedural hurdles that you need to be aware of when making (or changing) your inventory recording decisions. In some cases, making the wrong decision can seriously cost you.
The First-In-First-Out (FIFO) Inventory Management Strategy
For most businesses, FIFO is the preferred inventory valuation model. Whatever stock is purchased first is the first to be sold. Your COGS and balance sheets are tabulated accordingly.
For example, say you purchase 50 units of a product in January for $1 per unit. In March, you purchase an additional 50 units of the same product for $2 per unit. In April, you fulfill a customer’s order for 60 units.
The FIFO accounting method dictates that you sell off the 50 units from your January purchase as well as 10 units from the March purchase. This leaves you with 40 units purchased at the $2 per unit rate and a remaining total inventory value of $80.
There are a number of reasons why you should opt for a FIFO inventory reporting style:
- FIFO typically keeps your COGS as low as possible while keeping your inventory valuation figures high. This means optimizing your profit-per-sale while also maximizing the value of your unsold inventory for tax reporting. This is especially true in times of economic deflation. While this may not always result in the lowest-possible tax bill, it does typically demonstrate the type of profitability and economic solvency that banks and investors like to see.
- FIFO is particularly important for perishable goods that can become unsellable dead stock if left on your warehouse shelves for too long. With this approach, you can be sure that the inventory on hand is always the newest and freshest.
- FIFO bookkeeping is more straightforward than LIFO. Simply put, there is less likelihood of error or increased IRS scrutiny with FIFO recordkeeping.
- FIFO is the only inventory valuation model that can be used for international business. If your e-commerce business sells overseas, LIFO is not an option. The International Financial Reporting Standards (IFRS) strictly prohibits LIFO.
Despite its benefits, FIFO is not always necessarily the best option from an accounting perspective.
- FIFO can be disadvantageous in times of high inflation. When your oldest stock is more expensive than your newest, you inevitably face higher COGS rates and lower inventory valuation figures. This can be helpful from a tax perspective, but it has a definite negative impact on your overall profitability ratios.
- FIFO can paint a distorted picture of your finances. Particularly if you deal in rapidly-fluctuating markets and/or carry significant amounts of inventory, the prices being used to calculate your COGS in a FIFO model may reflect significantly different costs than what you are currently paying.
The Last-In-First-Out (LIFO) Inventory Management Strategy
Harkening back to the previous example, if you fulfill the same customer’s order for 60 units using the LIFO accounting method, you would start by selling off 50 units from your $2 per unit March purchase as well as 10 units from the $1 per unit January purchase. This leaves you with 40 units purchased at the $1 rate and a remaining total inventory value of $40.
In this instance, the LIFO model provides a more favorable tax benefit as you have both reduced the value of your inventory on hand while also reducing your profit margins. However, had the costs of the January and March inventory purchases been reversed, LIFO accounting would have resulted in a greater profit margin and a higher tax liability.
Therein lies one of the largest benefits of LIFO – particularly in times of high inflation, selling off higher-valued recent inventory first produces more favorable accounting results.
- LIFO can lower a company’s taxable income. When newer products purchased at a higher rate are sold first, COGS rates rise and profit margins shrink. This reduces your net income and, in turn, your business’s tax liability.
- LIFO provides benefits during periods of high economic inflation. Purchasing new inventory at higher and higher rates obviously hurts your bottom line, but the problem is exacerbated when you are paying taxes on COGS calculations relying on older, lower-priced inventory. The LIFO model can provide some relief against these types of inflationary issues.
- LIFO is only permissible for domestic sales. As previously mentioned, the International Financial Reporting Standards (IFRS) do not allow LIFO inventory reporting. If your e-commerce business currently sells overseas or if you plan on extending your business overseas in the near future, do not use LIFO.
- LIFO creates a more complicated bookkeeping burden than FIFO. By selling off your newest inventory first, you likely end up with layers of old stock that accumulates over time. As a result, you wind up carrying various quantities from multiple purchases and spanning multiple purchase prices. For this reason, it is highly recommended to use accounting and inventory-management platforms designed to handle this type of recordkeeping.
Deciding Between FIFO and LIFO for Your Omnichannel Business
Ultimately, only you can decide whether FIFO or LIFO makes more sense for your particular omnichannel e-commerce business. It is a decision you need to make carefully since switching from one inventory accounting method to another requires approval from the IRS, footnoting of numerous current and future financial documents reflecting the change, and sometimes even revisions of previous financial reports to reflect the new accounting method.
Not only that, there are also two other common inventory valuation methods to consider that may be more appropriate for your particular business and products:
- Specific identification is a hyper-precise inventory valuation method where each piece of inventory has its own specified cost attached to it. This is useful for sellers with one-of-a-kind items or products that have their own individual, trackable serial numbers.
- Weighted averages can be used as a way to account for the costs associated with commingled inventory purchased at different costs over a period of time. In this model, all inventory is being sold interchangeably, regardless of when it was actually acquired.
No matter which inventory valuation method you settle on, Sellercloud’s profit and loss (P&L) calculation features can help you keep your books in order. Our Quickbooks integration can make sure you are ready come tax time to report your profits and inventory valuation accurately.
For more on how Sellercloud can help you manage both your physical inventory and inventory-related data tracking, contact us directly for a free demo today.