LIFO Accounting: How the Last In, First Out Method Works

LIFO is a form of inventory accounting that stands for “last in, first out.” Companies use this accounting method to expense the inventory items they have most recently purchased or produced. Companies use the accounting method to expense the most recent inventory as the cost of goods sold (COGS) on financial statements.

LIFO is one of three generally accepted accounting principles (GAAP) in the United States. The other two are the “first in, first out method” (FIFO, in which companies sell the beginning inventory first) and the average cost method (in which business owners average unit costs from beginning to closing inventory). As a method of inventory management, LIFO typically lowers net income but is advantageous for tax purposes in times of inflation or rising prices.

LIFO is a form of reporting that aids inventory valuation and is a generally accepted accounting principle (GAAP) in the United States. International Financial Reporting Standards (IFRS), however, do not allow the LIFO method since it can distort financial statements.

The use of LIFO lowers taxable income and boosts higher cash flows when taxes rise. When there is zero inflation, income statements and cost flow cancel out to the same result, and the choice of inventory costing method does not matter. If inflation is high and large or small businesses have excess inventory, however, LIFO can result in lower net income taxes because the COGS, or the cost of goods sold, is higher.

LIFO is an accounting standard that can maximize inventory values. As an example of LIFO, imagine the fictional FastSpeed Car Company has one hundred used cars to sell sitting in inventory. Consider these aspects of revenue generation, from creating inventory to making the sales:

• Inventory: The first fifty cars the company produces cost $10,000 each to make. The last fifty vehicles the company produces cost $20,000 each to make. With the LIFO inventory management method, the last cars the company made should be the ones it sells first.
• Inventory costs: In this example, FastSpeed Car Company sells eighty cars in total. All vehicles have the same sales price, so revenue is the same, but the cost of the vehicles to the company depends on the inventory method it uses. Based on the LIFO method, the last inventory (the higher cost cars) should be the first to sell.
• Sales: With the LIFO method, the company first sells the fifty cars that cost $20,000 to make, then it sells thirty of the cars that cost $10,000 to make. The total inventory sells for $1.3 million (fifty at $20,000 and thirty at $10,000). Through LIFO accounting, paying a lower fee of taxable income by selling ending inventory when inflation and prices are up can benefit the company’s balance sheet. This is advantageous because it reduces the total cost of taxable income in IRS reporting.

LIFO (last in, first out) and FIFO (first in, first out) methods are both inventory valuation methods, but there are a few key differences:

• Cost of goods sold: Using LIFO, each item a company sells will increase the cost of goods sold. Companies calculate the ending inventory with the cost of the oldest inventory. In the FIFO method, the unit cost of the oldest inventory determines the COGS. If older products expire, the company is less likely to lose money.
• Inventory order: Companies using the LIFO inventory method sell the most recent inventory first. Using FIFO, companies sell the oldest inventory first.
• Net income: LIFO typically lowers the net income, whereas selling the oldest inventory first increases the net income.
• Taxes: The LIFO inventory method results in lower profits in times of higher inflation, which translates to lower taxes. This tax saving is advantageous to companies; when selling a large number of products in inventory, the amount companies owe in taxes lowers as prices rise. The FIFO method increases the net income, which can be good, but also means the company has to pay more in income taxes.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by business luminaries, including Sara Blakely, Chris Voss, Robin Roberts, Bob Iger, Howard Schultz, Anna Wintour, and more.