What is Last In, First Out?
Last in, first out (LIFO) is a method used to account for inventory that records the most recently produced items as sold first. Under LIFO, the cost of the most recent products purchased (or manufactured) is the first to be counted as cost of goods sold (COGS) – which means that the lower cost of older products will be reported in stock .
Two alternative inventory valuation methods include first in, first out (FIFO), where the oldest inventory items are recorded as sold first, and the average cost method, which takes the weighted average of all available units on sale during the accounting period and then uses this average cost to determine the COGS and complete the inventory.
Key points to remember
- LIFO is a method used to account for inventory.
- Under LIFO, the costs of the most recent products purchased (or manufactured) are the first to be expensed.
- LIFO is used only in the United States and governed by generally accepted accounting principles (GAAP).
Understanding the last in, first out (LIFO)
Last in, first out (LIFO) is only used in the United States, where the three methods of calculating inventory costs can be used according to generally accepted accounting principles (GAAP), because international reporting standards prohibit the use of the LIFO method. Companies that use LIFO stock assessments are usually those with relatively large stocks, such as retailers or car dealers, who may benefit from lower taxes (when prices go up) and higher cash flows. Many U.S. companies, however, prefer to use FIFO because if a company uses LIFO valuation when it files taxes, it must also use LIFO when it reports its financial results to shareholders, which reduces the bottom line and, ultimately, earnings per share.
LIFO, inflation and net income
When there is no zero inflation, the three methods of calculating inventory costs produce the same result. But if inflation is high, the choice of accounting method can significantly affect valuation ratios. FIFO, LIFO and the average cost have a different impact:
- FIFO provides a better indication of the value of the final inventory (on the balance sheet), but it also increases the bottom line, since the inventory, which may be several years old, is used to assess the COGS. The increase in net income looks good, but it can increase the taxes a business has to pay.
- LIFO is not a good indicator of the end-of-inventory value because it may underestimate the value of the inventory. LIFO results in lower net income (and taxes) because the COGS is higher. However, there is less depreciation of LIFO stocks during inflation.
- Average cost produces results somewhere between FIFO and LIFO.
If prices fall, then the complete opposite of the above is true.
Practical example: LIFO vs FIFO
Suppose 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 a day ago. Based on the LIFO inventory management method, the latest widgets are the first to be sold. Seven widgets are sold, but how much can the accountant record as a cost?
Each widget has the same sale price, so the income is the same, but the cost of the widgets is based on the inventory method selected. According to the LIFO method, the last inventory is the first inventory sold. This means that widgets that cost $ 200 were sold first. The company then sold two other $ 100 widgets. In total, the cost of LIFO widgets is $ 1,200, five to $ 200 and two to $ 100. In contrast, using FIFO, $ 100 widgets are sold first, followed by $ 200 widgets. Thus, the cost of the widgets sold will be recorded as $ 900, or five at $ 100 and two at $ 200.
This is why in times of rising prices, LIFO increases costs and lowers net income, which also reduces taxable income. Likewise, in times of falling prices, LIFO reduces costs and increases net income, which also increases taxable income.