How you identify items in inventory and determine which have been sold will depend on the nature of the products, the volume of products, how they are tracked, and inventory rotation. It will also depend on the uniformity or uniqueness of the products. For example, if you sell products that are custom made, you will probably be able to use the specific identification method. You will be able to determine the costs that make up each item in inventory.
FIFO and LIFO
If you cannot specifically identify the cost of each item in inventory, or the same types of goods are intermingled in your inventory and cannot be specifically matched to a particular sales invoice, you can use either the FIFO or LIFO inventory valuation method.
Under the FIFO (first-in-first-out) method, you assume that the goods you purchased or produced first (the goods that came into your inventory first) are the first ones to be sold or otherwise disposed of (the first ones to go out of your inventory). Therefore, at the end of the year, the items in inventory are assumed to be the last ones to be purchased or produced, and are valued at the most recent purchase or production prices.
Under the LIFO (last-in-first-out) method, you assume the opposite – that the last goods you purchased or produced are the first to be sold or disposed of. So your inventory at the end of the year consists of the earliest goods purchased or produced, valued at the earliest prices.
The inventory identification method you use will affect your inventory value and your cost of sales. During periods of rising prices, the FIFO method will generally result in a lower cost of sales amount than the LIFO method. When prices are falling, the opposite would be true.
Applying LIFO
Two of the pricing methods that can be used in applying LIFO for tax purposes are:
the dollar-value method, in which goods and products must be grouped into one or more pools or classes, depending on the kinds of items in inventory, and
the simplified dollar-value method, in which general categories of multiple pools of inventory are established. Annual changes in the prices of these pools of inventory are estimated based on the appropriate government price indexes.
The LIFO method is adopted by filing Internal Revenue Service (IRS) Form 970, Application To Use LIFO Inventory Method.