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

But what is FIFO?

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

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 5

What is LIFO then?

Day One

Day Two

  • 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

Day 4

Day 5

So What’s the Point of all of This?

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