Hello, I'm Professor Brian Bushee. Welcome back. In this video we're going to talk more about inventory cost flow assumptions. And if you've every been curious about what these terms LIFO and FIFO mean, this is the video for you. Because we're going to go through LIFO and FIFO in a lot of detail. Let's get started. We have to start out with a key assumption. And if you don't keep this assumption straight, you're going to be confused for much of the rest of this video. And, probably for the rest of your life. Anyway, the key assumption is that the, inventory cost flows do not have to follow the physical flow of goods. So what I mean by this is if we remember the inventory equation, where we have our Beginning Inventory plus New Inventory. That has to equal the Cost of Goods Sold, plus the Ending Inventory. Well, if you think of the physical flow of goods. The goods in Ending Inventory are whatever specific goods we haven't sold yet. And they're probably the newest goods. So, if we were buying and selling bananas. What we would do is we would sell the oldest bananas first. Those would go into cost of good sold. And we would keep the newest bananas in Ending Inventory. But for the flow of costs, and costs are what we're actually running through all the t-accounts and journal entries, the costs in Ending Inventory could either match the original cost of goods, so it could be the exact cost of each banana we hold in inventory. It could be the cost of of the most recent bananas we bought during the period. It could be the cost of bananas that we bought a long time ago. The oldest cost of bananas that we ever acquired. Or it could be an average of costs over time. And this number three is the one that people have trouble with. How could we use the oldest possible banana costs in Ending Inventory, when we have probably the newest bananas that we've acquired? Well, the reason is that the physical flow of goods, does not have to match the flow of costs. So make sure you keep that assumption straight. [SOUND] So let's talk in more detail about the specific inventory cost flow assumptions, starting with, specific identification. Under this method, we specifically identify the cost of each product that we sell. >> [SOUND] With computer technology today, I think companies should have to keep t-accounts for each individual good. Give me a compelling reason why any method other than Specific Identification should be used. >> Okay here's a compelling reason. What if you made toothpaste or a salad dressing, where you're taking gallons of liquids and chemicals and mixing them together in a big vat and drain things out the other side. How do you keep track of the, costs with specific ounce of toothpaste or salad dressing? In that case, you would need some kind of cost flow assumption. And even with more discrete products, and with today's computer technology. It would still take a lot of time and effort to keep track of these individual costs of individual products when you're making thousands or millions of products. The fact of the matter is that the costful assumptions we'll talk about will get you pretty close to the same answer anyway, without all the time or effort. Well, that is unless you use LIFO, which we'll talk about in a little bit. Another method that companies could use, and this is probably one of the most common methods, is FIFO or First-In, First-Out. That means that the oldest inventory costs go into cost of goods sold first. And so that the Ending Inventory represents the newest costs of the inventory that we acquired. [SOUND] The opposite way to do this would be LIFO, or Last-In, First-Out. Here the, newest inventory costs go into costs of goods sold first. So the, cost of the most recent purchases are the first costs that go out in the Cost of Goods Sold. And, what's left in Ending Inventory are the oldest costs. And, these could be costs that were incurred a long, long time ago. Because what we're doing every period is we're taking out the newest costs, leaving all the oldest costs behind. >> If I understand you correctly, you are insane. Why would a company sell the newest products first? They would always sell the oldest ones first; otherwise they would become obsolete. >> Exactly. A company that sold bananas or milk could never use LIFO. Just think how stinky their warehouse would be with all that old product. >> No, no, you already forgot the assumption that the physical flow of goods, does not have to match the flow of costs. A banana company would definitely sell the oldest bananas first. And keep the newest bananas in inventory, so everything would smell good. But in terms of the flow of costs, the banana company could still use LIFO, where the newest costs go into cost to get sold. The oldest costs are kept in inventory. And those old costs will not stink up the warehouse one bit. [SOUND] The last method you could use is called weighted average. Where you take an average cost of all inventory acquired and used that for both COGS and Ending Inventory. In practice, weighted average ends up giving results that look a lot like FIFO. So for the rest of the video, I'm not going to talk about weighted average, but instead focus on a comparison between FIFO and LIFO. So to highlight the, differences between FIFO and LIFO, I like to use this advertisement that I found, oh, I don't know, 13, 14 years ago in a levenger catalogue, which was called inventory management for newspapers. >> What are these things called newspapers? Are they the things that my grandpa used to deliver door-to-door in the old days? >> Yes. Prior to the Netscape IPO, in 1995, which popularized the internet. Many people actually got their news from pieces of paper called newspaper, which were delivered to their door every morning, and sometimes in the evening. And while you were a ten year old, probably sitting at home playing video games and eating Cheetos, when your grandfather was ten, he was out delivering these newspaper thingies at the crack of dawn, earning a nickel a day. I'm sorry to use such a stale example here but you know, it's probably not a bad thing to learn some ancient history every now and then. [SOUND] So anyway LIFO would be a system where you pull the newspapers from the top anytime you want to read a newspaper. Which would leave all the old newspapers at the bottom still in your inventory of newspapers. And this is probably how I wold use this trolley. But that's physical flow of goods. We really want to think about this in terms of costs. So imagine this is a trolley full of invoices. Every time you pay money for raw materials, labor, overhead, you put an invoice in the trolley. LIFO would say you pull the invoices or costs from the top. And those go into costs good sold. The invoices are costs that are still at the bottom, are the ones that are left in the Ending Inventory. And those are the oldest costs. [SOUND] For the FIFO method, which is really how this trolley was intended. You would throw your newspapers or, your invoices or costs into the trolley, but then you would pull them from the bottom, which means you take the oldest invoices or oldest costs out of the cost if it sold, and what's going to be left in your inventory of costs are the most recent invoices or the most recent costs. So that's the difference between LIFO and FIFO, but remember it's not flow of goods, it's flow of costs that we're talking about. So let's throw some numbers at this and see if we can do an example to see how LIFO versus FIFO can effect Cost of Goods Sold and Ending Inventory. In our example we're going to go back to 2010 and buy five units of inventory. We buy them in five separate months and as you can see the prices of buying the inventory are increasing as we go through the year. Now we're going to look at how to account for the inventory that we sell versus hold by the end of the year. So in 2010 we sold three of the five units. What we would do under FIFO is take the first three units that we purchase, the, $10 cost, the $15 cost and the $20 cost. And that would be our Cost of Goods Sold. The, two newest costs the 25 and the $30 would be in our ending inventories so we'd have COGS of 45 and Ending Inventory of 55. Now if we sell those same three units but use the LIFO method, to calculate COGS we need to start with the most recent cost and work backwards. So we would take 30, plus 25 plus 20 to end up with Cost of Goods Sold of 75. And then the two oldest costs, the 10 and the 15 would be what is left in Ending Inventory or 25. So as you can see there's a $30 difference in both Cost of Goods Sold and inventory between the FIFO method and LIFO method. >> How can you get different numbers for COGS? COGS is COGS. It is what it is. You are telling me that a simple accounting choice can have such a big effect on profits? >> Well, for COGS, you can't use the old, it is what it is, because every time you look at Cost of Goods Sold on the income statement, you're looking at a number that's the product of cost flow assumptions. And if the company used a different set of assumptions, they would have a different Cost of Goods Sold number. There's no true answer to what Cost of Goods Sold is, it's always a product of assumptions. And this is just one of many cases that we're going to look at in this course, where a very simple accounting choice can have a very dramatic effects on the balance sheet and the income statement. [SOUND] Continuing on into, 2011 we're going to start with different Beginning Inventory costs depending on whether we used FIFO or LIFO, FIFO's going to have the most recent costs in inventory whereas LIFO's going to have the oldest costs in inventory. In fact, another way that you could think about these is that FIFO is really LISH, Last-In, Still-Here, and LIFO is FISH, First-in, Still-Here. Although many people refer to LIFO by saying it backwards, which is OFIL, because it's an OFIL way to do accounting [LAUGH]. Anyway, we have different Beginning Inventory under FIFO and LIFO. Then we purchase three units during 2011, and the cost of those units are the same because we're buying them during the year. Now we're going to focus on FIFO and LIFO separately, starting with FIFO, so we sell three units during 2011, to figure out Cost of Goods Sold under FIFO we start with the oldest cost and move forward. So our Cost of Goods Sold will be 25 plus 30 plus 35 equals 90. Ending Inventory is the newest cost, so it's the 40 plus 45 gives you 85. [SOUND] Under LIFO, we sell three units, we have to start with the newest cost and work back. So Cost of Goods Sold will be 45 plus 40 plus 35, which is 120. Ending Inventories going to be the oldest cost which are the 10 plus the 15 giving us an Ending Inventory of 25. So comparing the two, COGS under LIFO is 120, $30 higher than COGS under FIFO of 90. What's happening is that prices are rising through this example. And anytime prices rise, FIFO is going to give you a lower Cost of Goods Sold than LIFO because LIFO is grabbing the newest, higher cost as part of Cost of Goods Sold, whereas FIFO is grabbing the older, lower cost as part of Cost of Goods Sold. >> You are insane. It simply is not plausible that companies could have such different values on the same goods in inventory! LIFO must require you keep the older goods! >> I am not insane, and this, in fact, does happen in the real world. LIFO became popular in the US sometime after World War II and if you look at companies that have been around since the 40's. You could see costs in their Ending Inventory from the 1940s, 1950s, 1960s, so some really old costs. But it's very unlikely that they still have goods from that long ago still in their inventory. Well, maybe if they're a US automaker, they still have some cars from the 40's that haven't sold. But for most companies, the goods are long gone. But don't worry about this problem of really all cost and inventory. In the next video, I'll show you a disclosure, which will allow you to see the inventory using more recent costs for LIFO firms. Let's finish off this example. In 2012, we come in with different Beginning Inventory, depending on whether it's FIFO or LIFO. And we're not going to buy anymore units, instead we're just going to sell the units that we have and go out of business. So under FIFO, we sell these two units and the Cost of Goods Sold is 85, so basically the costs of what's in the Beginning Inventory. Under LIFO, we sell these two units and the Cost of Goods Sold is $25, again, the cost of the two units that were in Beginning Inventory. So the difference in the Cost of Goods Sold is 60, with, this time, LIFO having lower Cost of Goods Sold than FIFO. [SOUND] The lower LIFO Cost of Goods Sold is due to dipping into old LIFO layers of inventory. Any time a company sells more inventory than it produces,. It ends up dipping into these old costs. Which, under LIFO, can be much lower than current costs. This is called a LIFO liquidation. And it has to be disclosed in the financial statements, due to its dramatic effect on, Costs of Goods Sold, and net income. Basically, giving the company an extra $60 of pre-tax income during 2012. >> So when a company says it is having a liquidation sale, does that refer to LIFO inventory? >> Not, not necessary. A liquidation sale simply means that you're trying to sell excess inventory. We use the term LIFO liquidation because it occurs when you sell more inventory than you produce, which often happens during a liquidation sale. But you can have a liquidation sale, even if you don't use LIFO for your inventory. Let's take a look at a summary of Cost of Goods over time for this example. As you can see in 2010 and 2011, FIFO had lower COGS by 30 each year. But then in 2012, FIFO had $60 higher COGS. Which means that the total COGS over the three years is identical. So FIFO versus LIFO changes the timing of Cost of Goods Sold, but over the life of the firm, total Cost of Goods Sold is going to be the same either way. >> Based on this chart I would think that every company uses FIFO. It gives you lower COGS in every period except the last, but by that point you are. >> You are dead. John Maynard Keynes said in the long run we are all dead. >> Wow, that's a cheery quote to inject into LIFO, FIFO video. Anyway, my point was that COGS are going to be the same over the life of the firm, whether you use LIFO or FIFO. Yes, maybe there are some motivations where you wanted lower Costs of Goods Sold earlier on and you would want to use FIFO, but actually, there is some strong motivations why you might want higher Cost of Goods Sold earlier on under LIFO. I'm going to talk about that motivation in the next slide. [SOUND] Lets talk about why it would matter whether a company uses LIFO or FIFO. [SOUND] When inventory cost are rising,. Which is generally the case because of inflation, Cost of Goods Sold under LIFO is higher and Ending Inventory under LIFO is lower compared to under FIFO. In the US tax reporting allows companies to use LIFO. So what that means is that if you have higher cost to goods sold under LIFO, you have lower taxable income, which means you pay less in taxes. So there are tax savings due to using LIFO, but the rule is that if you use LIFO for your taxes, you have to use LIFO for your financial statements. It's called the tax conformity rule. And it's one of the few places where tax reporting and financial reporting has to match up. So to show you, how big of deal this could be, let me bring up the summary of Costs of Goods Sold again. What we saw was that in 2010 and 2011, LIFO gave you lower pre-tax income by 30 each year and then higher pre-tax income in 2012. Now, in the US the tax rate is 35% and so what this translates to is in 2010 and 2011 you would save $10.5 in taxes each year, but then in 2012 you'd have to make up for it by paying an extra $21 in taxes under LIFO. It all cancels out over the three years. So you might be thinking, well what difference does it make? You save some taxes now, you pay some taxes later. But, it's the case that a Dollar today is always worth more than a Dollar in the future. And we'll talk about this later in the course when we talk about time value of money, but you always want to save taxes today. And be willing to pay taxes in the future, because the value of what you save today is worth more than what you're going to save in the future. [SOUND] The only catch is that IFRS does not permit the use of LIFO. The US is the only major country, that still allows LIFO. >> Let me get this straight. The US is the only country in the world that allows LIFO. LIFO is not allowed under IFRS. So, why are you wasting our time teaching it to us? >> Let me answer that. America is the most vital, important, and dominant country in the world. Who cares about you foreign. >> This is a good time to remind you that, the opinions expressed by Professor Brian Bushee, or by his virtual students, do not represent the views of the Wharton School, the University of Pennsylvania, its management, employees. Families, or casual acquaintances. These opinions solely represent the views of Professor Bushee, and his virtual students. We apologise in advance if you have been, are, or will be, offended by their comments. We ask that you direct all complaints, criticisms, disputes, and legal actions to professor Bushee. Having said that, we hope you are enjoying the course, let's return to the video, joined in progress. >> Citizens of the world, but anyway, even if you live outside the US, it's still important to know LIFO because if you ever have to compare a US firm to a non-US firm. And the US firm uses LIFO. There's some adjustments you need to make to get a reasonable comparison. And we're going to talk about those adjustments in the next video. I, I think I should wrap up here because I've got an urgent voice mail and all these text stuff on my phone. [SOUND] But anyway, in the next video, we're going to take a look at a financial statement disclosure for a LIFO firm, to see what kind of information we need to pull out so that we can compare a firm that uses LIFO for its inventory. To a firm that uses FIFO for it's inventory. I, I gotta go. I'll see you next video. >> See you next video.
