Understanding LIFO and FIFO Methods for Accounts Payable

When it comes to managing inventory and tracking costs, businesses have various accounting methods at their disposal. Two of the most common methods used are Last-In-First-Out (LIFO) and First-In-First-Out (FIFO). In this article, we'll delve into the specifics of each method and explore how they affect a business's accounts payable.

The LIFO Method

The LIFO method assumes that the items with the higher cost (those made last) sell first. This means that during times of inflation, when prices tend to increase over time, the LIFO method will have an opposite effect compared to FIFO. In other words, the business's net income may decrease due to the increased costs.

For example, let's consider a jeweler who produces gold rings. If the cost of production increases from $100 to $150 during the production cycle, the LIFO method would assume that these more expensive rings are sold first. This would result in a higher cost of goods sold compared to FIFO.

The FIFO Method

On the other hand, the FIFO method assumes that the items with the lower cost (those made first) sell first. During times of inflation, this means that the business's net income may increase due to the decreased costs. However, during deflation, when prices tend to decrease over time, the opposite effect occurs.

Using the same example as above, if the jeweler uses FIFO, they would list COGS at $100, regardless of the price it cost at the end of the production cycle. This could result in a lower cost of goods sold compared to LIFO.

Choosing the Right Method

When deciding which inventory costing method is best for their business, companies must consider how prices impact their operations. Depending on the industry and market conditions, one method may be more beneficial than the other. For instance, a business that experiences frequent price fluctuations due to seasonal demand or supply chain disruptions may benefit from using LIFO.

In conclusion, both LIFO and FIFO methods have their advantages and disadvantages. By understanding how these methods work and which one is best suited for their specific needs, businesses can make informed decisions about their inventory management and accounting practices.

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