For many automotive dealerships, inventory is one of the biggest assets your company has, if not the largest. As a result, your inventory makes up a large portion of your balance sheet. That is why, choosing the right inventory valuation method is so important. It determines how your inventory, and Cost of Goods Sold (COGS), will be valued on your financial statements.

To determine the value of your company’s inventory you will want to use the following calculation.

Ending Inventory = Beginning Inventory + Net Purchases - COGS

When choosing an accounting method for inventory valuation, it is important to consider your goals and the available options, as your inventory valuation will have a direct impact on your balance statement, income statement and cashflow. While there are many different valuation methods, the two most common inventory valuation methods are LIFO (Last In, First Out) and FIFO (First In, First Out).

The first method, LIFO assumes that the last unit purchased is the first to be sold. For example, assume you buy 10 oil filters on Monday at $6 a piece and then another 10 on Wednesday for $5. Using the LIFO method, if you sold 10 oil filters on Friday, the COGS would be $5 per filter because that was the cost of the last 10 oil filters to be purchased.

FIFO assumes the opposite – that the first part purchased is the first item sold. Using the FIFO method, the 10 oil filters sold on Friday would have a COGS of $6 each, because that was the cost of the first 10 oil filters purchased.

Choosing an Inventory Method When choosing between LIFO and FIFO, there are many things that should be taken into account. To help you select the best inventory valuation method for your specific situation, here are some common considerations.

Material Flow

For most businesses, the flow of materials is first in first out, meaning that the oldest items are taken off the shelf first allowing newer, fresher stock to be left on the shelves. In some industries, such as those selling Food and Beverage, this flow is made necessary through expiry dates. While automotive parts do not have best before dates, time can sometimes degrade parts and therefore, older parts should be used up first. Choosing the FIFO method, in this situation is the most logical choice. Inflation As costs increase, so do the profits on parts that were purchased first, when prices were lower. Using FIFO in this situation allows you to report increased profit on your financial statements but can also result in increased income tax payable come year end. On the other hand, newer parts will have higher costs, resulting in a lower profit (assuming all of the parts are sold at the same price, which is usually the case). If you implement LIFO, your tax liabilities should be lower.

Deflation

In comparison to the above example, if costs are decreasing, the first parts you purchased will have a higher COGS than those that were purchased most recently. As a result, the implications would reverse. Using FIFO, your profits would be lower, and your tax liability should decrease. If you use LIFO in a period of deflation, your profits would increase and so would your tax liability. Record Keeping Both LIFO and FIFO are referred to as cost layering techniques. Each time you add units to your inventory (i.e. make an additional purchase), another inventory layer is created. Generally, FIFO has less layers since the oldest layers are constantly sold. With LIFO, on the other hand, the oldest layers can remain in stock for years, depending on how often you repurchase new stock without completely depleting what you currently have on hand. This can create more layers, therefore increasing the amount of record keeping.

Internal Reporting

When using FIFO, the cost of inventory still in stock usually reflects current pricing with relative accuracy. As a result, your COGS will stay relatively stable. With LIFO, on the other hand, unusual increases or decreases may occur when older inventory is accessed. This is because, as stated above, when using the LIFO method, older costs can remain in your records for years.

Financial Reporting

When choosing an inventory valuation method, it is important to consider what is and isn’t allowed as per financial standards. While there are no GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) restrictions on the use of FIFO, the use of LIFO is prohibited. That being said, the IRS allows the use of both LIFO and FIFO. As a result, if you are using FIFO you will only have to value your inventory once. If you want to use LIFO for tax purposes, you will have to value your inventory twice – using LIFO for the IRS and FIFO for financial reporting.

For more information on these two inventory methods and how they apply to your specific situation, please contact your accountant. 

To get help with managing your automotive parts inventory, give us a call.