When choosing an accounting method for automotive inventory valuation, it is important to consider how each method will impact your goals, as well as what is practical for your business operations.
Inventory valuation and Cost of Goods Sold (COGS) are an important part of your financial statements, including your balance sheet, profit and loss and cash flow.
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).
LIFO assumes that the last unit purchased is the first to be sold.
Example: You buy 10 oil filters on Monday at $6 apiece 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. The remaining inventory would be valued at $60.
FIFO assumes the opposite – that the first part purchased is the first item sold.
Example: You buy 10 oil filters on Monday at $6 apiece and then another 10 on Wednesday for $5. 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.
For most businesses, the flow of materials is first in first out, meaning that the oldest items are taken off the shelf first allowing the newer 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.
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 an increased profit on your financial statements but can also result in increased income tax payable come the 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.
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.
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 fewer 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 you need to do.
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.
But internal reporting isn’t the only consideration. It is important to know what is and isn’t allowed as per financial standards.
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 Generally Accepted Accounting Principles (GAAP) restrictions with regards to using FIFO or LIFO, the International Financial Reporting Standards (IFRS) has prohibited the use of LIFO. You may also want to note that the Internal Revenue Service only allows companies to use LIFO if they also use LIFO for financial reporting purposes.
For more information on these two inventory methods and how they apply to your specific situation, please contact our team of automotive inventory experts today. We would love to answer any questions you have.
Tags: Auto Parts Inventory