What Is the Last In, First Out (LIFO) Method?

Inventory management is crucial for any product-based business. Keeping up with the total cost of goods sold (COGS) allows small business owners to gain a more accurate picture of their company's profitability and anticipate what they will owe the Internal Revenue Service (IRS) at tax time. There are a few ways to approach inventory management, one being the Last In, First Out (LIFO) method of inventory valuation.

Due to inflation and other economic changes, the newer products in a company's inventory will often increase in price compared to the older products. When utilizing the LIFO method of inventory, the most recent inventory items that a company has acquired are used in the calculation of the company's COGS because this assumption of last in, first out allows for a tax break. For this reason, LIFO can represent a vital piece of small business accounting.

This article will explain the process and ideas behind LIFO inventory and show ways that LIFO might be integrated into your small business accounting method.

What Is LIFO Inventory Management?

Inventory value under LIFO is established by costing the last item a business bought rather than the first item a business sold when tallying that business's total profitability. For tax purposes, this means that what gets reflected in your company's financial statements is the naturally higher price of the more recent inventory. LIFO addresses rising prices by leaving the lower-cost, older inventory out of the metrics of the business's gross profit.

It's important to note that LIFO inventory accounting is allowed under Generally Accepted Accounting Principles (GAAP) but not under International Financial Reporting Standards (IFRS). This means that LIFO is only legal in the United States, as much of the remainder of the world primarily utilizes IFRS, which is focused on a first-in, first-out (FIFO) approach.

Inventory cost goes a long way toward determining what kind of taxable income a company will report to the IRS. While the LIFO inventory valuation method may initially cause a company to show a decrease in cash flow, if the higher unit cost associated with the last item continues over any considerable length of time, that LIFO reserve can spell major savings.

What Is the Difference Between the FIFO and LIFO Methods?

The FIFO cost method works oppositely to LIFO and evaluates the COGS across accounting periods by assuming that the oldest inventory is the first out the door in terms of sales. This first-out method means that the lower cost of older items will determine a company's net income on the balance sheet.

The FIFO method is preferred by IFRS because it provides a more accurate picture by accounting for older products first. However, use of LIFO is legal in the United States and is frequently the inventory value measure chosen by businesses because of the tax break it can afford by reflecting profitability through the higher prices of current inventory.

Key Takeaways

• FIFO measures the cost of a company's oldest inventory when calculating the COGS.
• The first in, first out approach of FIFO means reporting a higher gross profit per accounting period.
• LIFO inventory costing accounts for the last item a company stocked when calculating the COGS.
• The last in, first out approach of LIFO means reporting a lower gross profit but obtaining a tax break.

What Are the Benefits and Disadvantages of the LIFO Method?

LIFO accounting, like any other financial format, comes with positive and negative aspects. The following represent several pros and cons of using LIFO:

LIFO Method Benefits

• Improved income statement quality: Recent inventory under LIFO is matched directly with revenue from the sale of inventory. Because newer inventory cost is higher, the matching is better on a LIFO balance sheet than what would occur under the FIFO method.
• Allowed in the U.S. under GAAP: In particular, U.S. companies that operate with a large inventory, such as retail shops or automotive dealerships, can benefit from the LIFO method for tax purposes. LIFO inventory allows companies to take advantage of the higher prices associated with obtaining their most recent inventory.
• Produces a larger COGS: By looking at the most recent inventory that a company has acquired, the LIFO method allows a company to report a higher COGS. Although this causes a lower net income report on the balance sheet, great savings can be had through that LIFO reserve over time.
• Lower ending inventory: Ending inventory using LIFO costing methods is realized by examining the cost of the last item a company purchased. Assuming that the price of the last item purchased is equivalent to the price of the first item sold (and that the most recent items purchased sold first) allows LIFO to allocate the oldest inventory a company bought into the ending inventory. Because these items typically were purchased at a lower cost, ending inventory numbers under LIFO are lower.
• Lower balance sheet valuation: Because outdated inventory is left on the balance sheet indefinitely in LIFO inventory accounting, your financial statements can show a lower quality of overall information about your company's inventory. When a business sells a newer item at a higher cost and only expenses that higher-cost item, the real unit cost of the oldest inventory is not truly reflected.
• Prohibited under IFRS: While LIFO inventory costing is allowed in the U.S., it's not permissible elsewhere. This may impact companies who have interests overseas or wish to expand to an international market.
• More complex bookkeeping: LIFO inventory accounting requires more time and effort than some other inventory valuation methods. However, if you have reliable software products, like those available with Skynova, keeping LIFO logs doesn't have to come with additional stress.

LIFO Method Disadvantages

• Lower balance sheet valuation: Because outdated inventory is left on the balance sheet indefinitely in LIFO inventory accounting, your financial statements can show a lower quality of overall information about your company's inventory. When a business sells a newer item at a higher cost and only expenses that higher-cost item, the real unit cost of the oldest inventory is not truly reflected.
• Prohibited under IFRS: While LIFO inventory costing is allowed in the U.S., it's not permissible elsewhere. This may impact companies who have interests overseas or wish to expand to an international market.
• More complex bookkeeping: LIFO inventory accounting requires more time and effort than some other inventory valuation methods. However, if you have reliable software products, like those available with Skynova, keeping LIFO logs doesn't have to come with additional stress.

What Is an Example of Using the LIFO Method?

To gain a better grasp of LIFO metrics, let's take a look at a practical example. Let's say Lisa owns a small florist shop. In recent years, Lisa has made most of her store's profit from the sale of tulips but steady increases in overseas shipping costs have caused her tulip inventory to cost Lisa more and more. The following table illustrates what Lisa has been paying to keep up her tulip inventory:

Before the year midpoint, Lisa tallies up her total sales and records that she has sold 200 tulips. She would now like to generate a profitability report for this accounting period wherein she can calculate her COGS.

Using a LIFO inventory method, Lisa would begin with the inventory cost of her most recent items, which is $47.75. However, the 200 tulips that Lisa sold during this time weren't sold at that price. The following table illustrates how Lisa can accurately calculate her COGS using LIFO:

The 200 tulips Lisa sold during this accounting period will now move from being labeled as inventory to being labeled as the COGS on the balance sheet. Whatever tulips Lisa didn't sell during this time remain listed as inventory.

Keep Accurate Inventory Records Using Skynova

Every small business owner wants inventory management to be as straightforward and profitable as possible. When you use Skynova's accounting software, your company's purchase orders, invoices, and receipts are organized into a single, usable space that is simple to understand.

Skynova's business templates and software products can also provide the support you require without the hassle. Check out Skynova when making decisions about the use of LIFO or any other small business accounting needs.

Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a certified public accountant (CPA) before deciding that LIFO or any other financial accounting method is right for your business and ensure that your company stays in alignment with established accounting standards.