Inventory Accounting Methods for Manufacturers: Making the Best Choice

Written by: Caleb Macaluso

The accounting method you choose to value your manufacturing company's inventory can have a major effect on your tax obligations as well as other important factors. To help you better understand the methods available and navigate this decision, we’ve answered some important questions about the tax and financial implications of the two most widely used methods: first-in, first-out (FIFO) and last-in, first-out (LIFO).

Your inventory's value is part of the formula for determining the cost of goods sold (COGS). COGS, in turn, affects your taxable income.

COGS generally is the sum of the beginning inventory and purchased inventory, less the ending inventory. As your COGS expense drops, your reportable income increases, along with your tax bill. On the flip side, your tax liability falls as your COGS expense climbs. The "LIFO conformity rule" generally requires companies to use the same inventory accounting method for tax and financial statement purposes.

The FIFO method assumes that a manufacturer sells its inventory in the same order that it was manufactured. That means the items in your inventory at the end of a reporting period are the most recently made, so the inventory's value is computed based on the most recent cost. This method reflects the real-world physical inventory movement for most manufacturers, particularly those that produce perishable products or goods that become obsolete after a certain period.

Because costs tend to rise over time, the FIFO method generally results in the older and less expensive inventory items being charged to COGS first; while the more recent and costlier items remain on the balance sheet. Under FIFO, COGS is generally lower and profits are greater, resulting in an increased income tax liability.

Conversely, the LIFO approach assumes manufacturers sell their most recently created items first. It's therefore most often employed when the manufactured items have a longer "shelf life," such as clothing and heavy machinery. But most companies don't leave older items sitting in stock.

When prices are on the rise, your inventory under LIFO will comprise older and cheaper products, and the newer and more costly items will be charged to COGS first. With a higher COGS, profits and income taxes are generally lower under LIFO.

The LIFO method is available only under U.S. Generally Accepted Accounting Principles (GAAP) — it's not permitted under International Financial Reporting Standards (IFRS). If you're subject to IFRS reporting requirements, opting for the LIFO approach for GAAP purposes will complicate your IFRS reporting.

Manufacturers should look beyond just the tax implications when selecting or changing their inventory accounting method. Additional factors could end up outweighing the tax benefits.

For example, FIFO is generally easier to apply than LIFO, and it typically will give you a stronger balance sheet because the inventory asset will be higher. The profits reported on your income statement generally also will be higher. These upsides could be beneficial when reporting financial results to investors or lenders. Assuming FIFO reflects your actual processes, your inventory value will be more accurate. On the other hand, your cash flow and profitability may appear healthier than they are in reality.

As for LIFO, it usually reduces taxes in inflationary periods because it reduces profits, but this isn't always a good thing. Lower profits can work against you when you're seeking investors or applying for credit. Also the value of your inventory may be artificially undervalued during inflationary periods.

In addition, the IRS requires taxpayers to formally elect to use the LIFO method on IRS Form 970, "Application to Use LIFO Inventory Method." The election can't be revoked to return to FIFO unless you first obtain IRS permission. And, of course, LIFO could be less accurate because some of the older items in your inventory may not be sellable anymore due to age or obsolescence.

Also, beware: The use of LIFO can create a problem if inventory levels are declining. As higher inventory costs are used up, companies that use LIFO will need to start dipping into lower-cost layers of inventory, triggering taxes on "phantom income" that the LIFO method previously allowed the company to defer.

Additionally, if a C corporation elects S corporation status, the business must include a "LIFO recapture amount" in income for the C corporation's last tax year. The recapture amount is the excess of the inventory's value using FIFO over its value using LIFO. Under current tax law, taxpayers can spread out the payments over four years in equal, interest-free installments.

Of course, if your company manufactures unique items based on customer specifications or your products take longer than a year to produce, neither FIFO nor LIFO may be appropriate. These manufacturers may use alternative inventory accounting methods, such as the specific identification or percentage of completion methods.

Selecting the right inventory accounting method is a critical decision with significant impacts on your manufacturing company’s taxes, net income, and overall financial health. These effects extend to key areas like your balance sheet, creditworthiness, and ability to raise capital.

Partnering with a strong firm like CSH will ensure that you’re making the best decisions for your organization. While any accounting method you select might work for your business, our experienced team will analyze your overall situation and help you implement or maintain practices that maximize your position. CSH is here to guide you in choosing the best accounting method tailored to your unique organization.

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