Paper Profits

Do you know your FIFO from your LIFO?

There two strategies you need to be familiar with if you want to run a successful retail organisation that can be summarised with the FIFO acronym.

The first, I wrote about here. It is about creating happy workplaces. And how hard it is to apply the Fit In or … rule. But today I would like to write about the other FIFO.

The other use of FIFO is of coursed as opposed to LIFO. That is: First In First Out <> Last In First Out.

The latter of course relates to how you choose to value your inventory. I would not know for sure, but I guess many independent retailers would rely on their accountant to make the decision about how their inventory is valued.

You may argue that you trust your accountant, but do you also trust the accountant of the person whose business you might be buying? Or do you understand how it may impact your own business valuation?

Let’s look at a simple scenario where a retailer sells only one product: say exclusive watches.

Under both scenarios, you sell 100 watches at $10,000 each.

You start the year with 40 watches in stock and they were purchased (and are valued) at $4,000 each.

During the year, you purchase 100 watches (to maintain stock levels), so you end the year again with 40 watches in stock. (I know it is unrealistic, but I do this to keep it simple.)

But these purchases are made at the following prices:

  • ·        Purchase #1: 50 watches $4,500.
  • ·        Purchase #2: 50 watches at $5,000.

You don’t change your prices because there is a new competitor and you need to maintain price parity.

The difference between the two scenarios is simply that you have a choice as to whether your ending inventory is valued at $4,500 ea (LIFO) or $5,000 ea (FIFO).

 

If you remember this, you will always remember the difference:

If you adopt FIFO, then it means that the GOODS SOLD FIRST = the cheap(er) stuff.

FIFO therefore means that the remaining stock is at the HIGHER price, resulting in LOWER Cost of sales. (Lower COS = sold the cheaper stock = higher GM.)

If you adopt LIFO, then it means that the GOODS SOLD FIRST = the more expensive stuff.

 

LIFO therefore means that the remaining stock is at the LOWER price, resulting in HIGHER Cost of Sales. (Higher COS = sold the cheaper stock = lower GM.)

Consider the following diagrams to visually understand what the difference between FIFO and LIFO is.

 

 

[In the real world of course your ending inventory may be ‘weighted’. Your purchasing cycle may have been different and if you purchased 80 watches at $4,500 and only 20 at $5,000 your ending inventory under FIFO would be: 40 watches, valued at (20 x $5000) PLUS 20 x ($4,500) = $190,000.]

During high-inflation periods you would want to use LIFO because you want to match your costs to your prices. But FIFO results in ‘inventory profits’ and this should be considered when you are buying a business. (Your current/ replacement stock will result in lower profit when you have to buy at the higher price and can’t match that with a price increase.)

Higher profits may seem desirable, but it also means higher tax.

Footnote: *Under International Accounting Standards LIFO was disallowed, but then, not everyone complies. But I also understand that it is under appeal. Ask your accountant what the status is in your industry/sector in Australia.