ELI5- Part 2: LIFO and FIFO aren’t just great pet names
…they are inventory methods that can have a serious impact on the way your income is taxed. They can also be used with holding periods (read more about holding periods here) to create real saving opportunities.
But what is FIFO?
To get a better understanding of what FIFO is, we are making up a business out of thin air. It is the same business that we are using for the explanation of LIFO (scroll further down), so if this seems all too familiar, that’s because it is.
Mac the Miller — Passion for Inventory
Imagine this scenario:
- For the sake of the story, we are called Mac and we are in the business of milling grains
- We have a (very, very slow, but very, very efficient) wheat mill in our backyard with a capacity of turning 50 lbs of wheat into 50 lbs of flour per day, and a silo with infinite space in the front.
- The operational milling cost amounts to $1 per lbs of grains for bags, linen and other expenses.
- The milling season has just started, so we are buying wheat from different farmers in the surrounding area.
- Our business doesn’t just provide the service of milling, we actually buy the wheat from the farmers and resell it as flour on the market.
- During the first few days, the market is very volatile and we buy flour at vastly different prices. Obviously, we buy more per day than the capacity of our mill because we want to fill up our silos and make the milling season last as long as possible.
We buy 100 lbs of grains every day at different price points:
- On day one, we buy 100 lbs at $1 per lbs.
- On day two, we buy 100 lbs at $5 per lbs.
- On day three, we buy 100 lbs at $3 per lbs.
- On day four, we buy 100 lbs at $7 per lbs.
- On day five, we buy 100 lbs at $10 per lbs.
Of course, we don’t only buy the grains, we also grind them up.
Right smack dab in the middle of milling season, bad timing as always, the local tax man comes by and says: “Hey Mac! I know you have a whole lot of wheat in that silo of yours. Please let me know what the value of all of this stuff is!”
Now, the problem is that all of the wheat looks exactly the same. You can’t say: “Well, these few grains are from Farmer Steve, I paid $3 for them, those grains over there are from Farmer Richie” and so on.
In order to make this whole process easier, there are a few accounting methods that simplify this process. The most common ones are called “FIFO” and “LIFO”. There are others (like “HIFO” or just a model of averages) but FIFO and LIFO are the most commonly used methods.
FIFO — First in, First out
You’ll have heard about this if you’ve ever spent any time in an accounting class.
The concept for FIFO is quite intuitive:
The first thing you buy is the first thing you use. Especially for us, running a mill and all, FIFO seems the most useful.
You fill the silo from the top, but the outlet for the mill is at the bottom. What you put in on day 2, is therefore only used up after all of the grains from day one are gone. The grains put in first get used up first. What comes in first, goes out first. First in, first out. FIFO.
Let’s see what that looks like for our mill:
On day one, you buy 100 lbs at $1 per lbs. The truck carrying the grains dumps all of the 100 lbs into your silo. You move half of it to the mill and grind up 50 lbs of grains, so at the end of the day, you have 50 lbs of flour with a book value of $50 (plus whatever cost you incurred grinding) and 50 lbs of wheat with a book value of $50 for materials and $50 for operational expenses, so a total book value of $150.
On day two, you buy another 100 lbs but it’s much more expensive even though the wheat is exactly the same. Maybe it’s the weather or some other market forces at play. You buy it at $5 per lbs.
Again, you turn 50 lbs into flour, which costs you $50 in operational expenses and now hold 100 lbs.
If someone now asks you the book value of the wheat in your silos, it becomes very difficult without a proper method.
With FIFO, you calculate in a way that the grain you bought first is also the grain you are milling first. So the book value on day two is as follows:
- You grind up another 50 lbs at $1 per lbs.
- You now have 100 lbs of flour at $1 per pound plus operational cost of $100.
- All of the wheat that remains in your silo now has a book value of $5 per lbs.
Day 3 works very similar to days number 1 and 2. However, you already have 100 lbs at the start of the day (at a value of $5 per pound) and so you start off milling the grains from day 2.
You also buy another 100 lbs at $3 per pound as the prices have relaxed a little compared to the day before.
Looking at your book value, you are now actually creating a much more valuable flour than you had the days before as the grains have a book value of $5 per pound. You end up with an additional operational cost of $50 for the day as well as 50 lbs of flour, so the total value created for flour is $300.
The table below shows the value of grains in your silo as well as that of the flour in storage at the end of day three.
As you can see, the 150 lbs of grains are worth more than the 150 lbs of flour. Of course, this is due to the accounting method rather than the actual marketable value of the flour. But this can come in handy when you want to show lower or higher profits.
Day four is very similar to the other days. You use up the rest of the grains from day two and now have 200 lbs in your silos with a book value of $3 for the first 100 lbs and $7 for the grains bought on day 4.
Now, the difference of value has increased even more and your 200 lbs of grains is worth $200 more than your 200 lbs of flour, even though you have already added operational expenses to the flour production.
Day five is really bad. It is right at the end of the harvest and the harvest is much worse than everyone had initially thought. Therefore, you have to pay $10 per lbs to fill your silo up with another 100 pounds of grains.
You are now milling the comparatively cheap grains from day three so your 250 lbs of flour are worth $1,000 while the same amount of grains is worth 1,850. As you can see, there is now a substantial difference between the grains and flour.
At any given point in time, the book value of the available grains and flour is known, even though the actual grains might be distributed differently. This is especially helpful when the book value is important i.e. for tax returns or insurance claims.
With rising prices, you ensure that the book value of your end product is fairly low. If prices are falling, FIFO gives you the opposite and boosts asset values for products artificially.
But what if you want to create the opposite effect? Well, that’s what LIFO can do.
What is LIFO then?
If you were standing at the front of the line somewhere and that line had LIFO, you would probably get angry pretty quickly. LIFO is an inventory method in which the last product that comes in is also the first that gets used up.
Imagine you have a box of tennis balls and you just keep dumping more in. Instead of digging for the one at the bottom that got in first, you will probably grab the one conveniently placed at the very top of the box. This is the principle of LIFO.
We are again using Mac the Miller as our model of choice to understand inventory methods.
Compared to FIFO, nothing changes on day one. You still buy 100 lbs of grains for $100 and convert 50 lbs into flour so you end up with the same table:
Day two however is already different. Instead of letting the truck dump the whole load into your silo, you take half of the grains right to the mill and grind them up there. You grind up 50 lbs at $5 per lbs and the asset value changes.
- You grind up 50 lbs at $5 per lbs.
- You now have 50 lbs of flour at $1 per pound and 50 lbs at $5 per pound plus operational cost of $100.
- 50 lbs of the wheat that remains in your silo now has a book value of $1 per lbs and another 50 lbs has a value of $5 per pound.
While the total value of your assets is still $700, and thus just the same as it is in FIFO, the distribution of value changes. Now, the value of the flour is much higher than that of grains.
On day three, you instruct the truck to again take 50 lbs to the mill right away.
The rest of the haul goes right into the silo.
Day four is just more of the same. The truck driver already knows to make two stops with 50 lbs each.
At the end of day five, there are 250 lbs of flour and grains, the grains are worth $1,300 and the flour is worth $1,500.
So What’s the Point of all of This?
So where does that leave us? First of all, without using a proper inventory method, it is impossible to tell your finance authority how much money you made, which will lead to a lot of trouble.
You can now tell Mr. T. Axman the value of all of your assets, you can tell him how much your grain and flour is worth and he is happy with your answers. For now that is. In the following table, we have summarized the total value of your assets using both the FIFO and LIFO methods.
So what’s the point of any of this if the total asset value is exactly the same? Did you just read 2,000 words, looked at cool illustrations and read a bunch of tables for nothing?
Not so fast.
Before closing this window in a rage, consider another option:
Imagine you don’t only buy grains and produce flour, imagine that you also sell some of the flour.
Let’s say at the end of day 4, we sell 150 pounds of flour at $10 per lbs. We make $1,500 and are quite happy with the results.
But Mr. T. Axman is already waiting in the bushes. “How much money did you make? Did you pay VAT? What kind of profit did you make?
While the first question is easily answered (after all, we have already established that 150 times 10 is 1,500) and the second question is irrelevant to us at the moment, the third one is very interesting for us. Depending on the way we calculate our inventories, we can plan our profits differently.
In LIFO, we take the flour produced last and sell it. We sell 50 lbs from today (day 4), 50 from yesterday (day 3) and 50 from day 2. After receiving our $1,500 in cash, we hand over 150 lbs of flour and take it from our books. When using LIFO, 150 lbs are worth ($400+$200+$300=)$900. Our profit for this period then amounts to ($1,500-$900=)$600.
In FIFO, we sell the flour that we produced first. We sell 50 lbs from day 1, 50 from day 2 and another 50 pounds from day 3. The revenue is the same at $1,500, but the outgoing value is different at ($100+$100+$300=)$500. Our profit in this period amounts to $1,000.
At a tax rate of 25%, we would pay an income tax of $150 in LIFO and $250 in FIFO even though we have not changed anything about the process. In this example, we are able to either maximize our asset value or minimize our profits.
These FIFO and LIFO inventory principles also exist in the crypto world. Especially with the consideration of holding periods, FIFO accounting can be very favourable for investors as older investments might have lower tax rates than newer ones.
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