Last In, First Out (LIFO): The Inventory Cost Method Explained

What Is Last In, First Out (LIFO)?

Last in, first out (LIFO) is a method used to account for business inventory that records the most recently produced items in a series as the ones that are sold first. That is, the cost of the most recent products purchased or produced is the first to be expensed as cost of goods sold (COGS), while the cost of older products, which is often lower, will be reported as inventory.

Two alternative methods of inventory costing include first in, first out (FIFO), in which the oldest inventory items are recorded as sold first, and the average cost method, which takes the weighted average of all units available for sale during the accounting period and uses that average cost to determine COGS and ending inventory.

Understanding Last In, First Out (LIFO)

Last in, first out (LIFO) is only used in the United States where any of the three inventory-costing methods can be used under generally accepted accounting principles (GAAP). The International Financial Reporting Standards (IFRS), which is used in most countries, forbids the use of the LIFO method.

Most companies that use LIFO inventory valuations need to maintain large inventories, such as retailers and auto dealerships. The method allows them to take advantage of lower taxable income and higher cash flow when their expenses are rising.

Most U.S. public companies prefer to use FIFO. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income.

LIFO, Inflation, and Net Income

When there is zero inflation, all three inventory-costing methods produce the same result. But if inflation is high, the choice of accounting method can dramatically affect valuation ratios. FIFO, LIFO, and average cost have different impacts:

• FIFO provides a better indication of the value of ending inventory on the balance sheet, but it also increases net income because inventory that might be several years old is used to value COGS. Increasing net income sounds good, but it can increase the taxes that a company must pay.
• LIFO is not a good indicator of ending inventory value because it may understate the value of inventory. LIFO results in lower net income (and taxes) because COGS is higher. However, there are fewer inventory write-downs under LIFO during inflation.
• Average cost produces results that fall somewhere between FIFO and LIFO.

In times of deflation, the complete opposite of the above is true.

Example of LIFO

Assume company A has 10 widgets. The first five widgets cost $100 each and arrived two days ago. The last five widgets cost $200 each and arrived one day ago. Based on the LIFO method of inventory management, the last widgets in are the first ones to be sold. Seven widgets are sold, but how much can the accountant record as a cost?

Each widget has the same sales price, so revenue is the same. But the cost of the widgets is based on the inventory method selected.

Based on the LIFO method, the last inventory in is the first inventory sold. This means the widgets that cost $200 sold first. The company then sold two more of the $100 widgets. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100.

In contrast, using the FIFO method, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200.

This is why LIFO creates higher costs and lowers net income in times of inflation. It also reduces taxable income.

In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income.

The Bottom Line

Most companies use the first in, first out (FIFO) method of accounting to record their sales. The last in, first out (LIFO) method is suited to particular businesses in particular times. That is, it is used primarily by businesses that must maintain large and costly inventories, and it is useful only when inflation is rapidly pushing up their costs. It allows them to record lower taxable income at times when higher prices are putting stress on their operations.