ELI5- Part 2: LIFO and FIFO aren’t just great pet names

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

  • 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.
  • 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.

FIFO — First in, First out

You’ll have heard about this if you’ve ever spent any time in an accounting class.

Day One:

Day Two

  • 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

Day 4

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.

Day 5

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.

What is LIFO then?

Day One

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

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.

Day 3

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 4

Day four is just more of the same. The truck driver already knows to make two stops with 50 lbs each.

Day 5

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.

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