FIFO & LIFO approaches can be hard to understand because even though they are clearly different, they don’t seem to make a lot of sense at first. Why distinct them, and what use are they? You’ll have to understand what they are before getting into the LIFO Reserve subject because, otherwise, that would make even less sense.
These three (FIFO, LIFO, and LIFO reserve) are used in accounting to compare the inventory costs of the companies. The companies themselves use these to manage the costs of the stuff they produce, which is crucial for many small reasons. In accounting, you can compare the costs for different companies.
If two companies use the same approach, then comparing is easy. However, often both companies use two approaches simultaneously, which complicates things. Reserve basically condenses two parameters into one for your comfort.
What are LIFO and FIFO?
These stand for ‘Last in Last out’ and ‘First in First out’. These refer to the order in which the company utilizes its resources (the inventory) to sell its products. With FIFO, it uses the resources it acquired earliest to create its earliest products. With LIFO, the last resources would be used to create the earliest products.
That’s how it registers its resources tax-wise, and that’s how it manages its costs. Both these approaches have their merits and advantages, they aren’t just for convenience.
It’s important to note that by the time businesses come around to start producing the products with the inventory, the earliest-bought resources wouldn’t be as valuable as later resources, seeing how they would be newer.
As a rule, it usually means that the prices will probably decrease (although there are many more parameters that needed to be taken into account to say for sure). With FIFO, the product’s price change will likely be smoother.
FIFO is usually utilized for the domestic market. So, if the prices in the domestic market are rising, then the prices on the products sold with FIFO will also climb (usually), which won’t contradict the market. LIFO, by contrast, is used for tax advantages, and mostly for the outside market – it’s complicated, and not a terribly relevant subject.
Why LIFO Reserve?
While comparing FIFO-using companies and LIFO-using companies is simple, there are lots of entities that use both FIFO and LIFO approaches in different instances. To compare these businesses, you’ll have to combine two parameters (LIFO and FIFO) into one (LIFO Reserve).
The Reserve is simply the LIFO Inventory subtracted from the FIFO Inventory of the same company. So, it looks like this:
FIFO – LIFO = LIFO Reserve
After you’ve calculated this for at least two companies, you’ll be able to compare the numbers and use this new information for your own evaluation, whatever it may be. This info isn’t terribly crucial, but it helps you understand just how well the company handles its inventory and how much it loses in general.