The two most commonly used methods to account for the cost of inventory at the time it is sold are "first in, first out" (FIFO) and "last in, first out" (LIFO). FIFO assumes that items are sold in the order they are acquired, while LIFO is the opposite—when products are sold, the most recent inventory is accounted for first. The question of whether FIFO or LIFO is best for an individual company depends on a number of variables. Whichever method a business chooses, inventory accounting software
can make it easy to ensure compliance with inventory legislation
.The pros and cons of FIFO
As the Houston Chronicle notes
, FIFO is "a more natural straight-line approach since you account for your first inventory in as the first items sold." Companies that use FIFO include those which sell goods with short shelf lives—perishable foods, for example—and proponents of the inventory accounting method argue that FIFO is more logical. However, during periods of regular price inflation in which inventory costs rise over time, businesses' taxable income tends to be higher if they use FIFO because the cost basis on initial inventory received is usually less. According to the Chronicle, tricky inventory tracking is another disadvantage associated with FIFO, as the method involves purchasing varying amounts of inventory at different times.The pros and cons of LIFO
Companies grappling with rising item costs—such as manufacturers and retailers—may turn to LIFO to generate less taxable income and lower income tax payments. AZCentral explains
that LIFO "provides a more accurate depiction of the costs of inventory at the present time when it was sold," but also acknowledges that critics claim it is "less realistic in presenting a company's financial situation since costs aren't aligned with the logical progression of inventory as it is sold."
Additionally, as the Chronicle notes
, electing to use a LIFO valuation approach is a significant commitment, because companies that do so are typically prohibited from switching to FIFO for several years, unless they secure permission from the Internal Revenue Service.
Regardless of whether a business implements LIFO or FIFO, having a comprehensive inventory tracking system in place is crucial. Inventory software
takes much of this responsibility off company owners and employees by automating the process.