LIFO, the acronym stands for Last-In-First-Out. It is an inventory accounting method where goods produced or purchased most recently are recorded as sold first. The cost of the newest products are the first to be accounted as cost of goods sold (COGS) whereas the lower prices of older goods are counted in inventory.
The opposite to LIFO is FIFO, which stands for First-In-First-Out. In FIFO, the oldest inventory is recorded as sold first.
Practical Application of LIFO
An important thing to remember is that LIFO is a cost flow assumption meaning the flow of cost from inventory to COGS does not necessarily have to match the actual flow of goods. The company could be shipping oldest inventory units in reality.
LIFO is practiced with the assumption that prices are rising steadily, therefore, most recently acquired inventory would be of the highest cost. Selling off newest inventory will yield lower profits, yet that would mean a lower taxable income too.
LIFO is only practiced in the United States as the International Financial Reporting Standards denies its use in other countries. The only reason that LIFO is used is due to the reduced taxable income. Companies that use LIFO are usually those with very large inventories, like automobile dealerships, or large-scale retailers. They can advantage of the higher cash flow and lowered taxes.
How is LIFO connected to Income and Taxes?
In times of inflation, LIFO is preferable as companies can sell newest stock at their peak price making cost of goods sold(COGS) higher but the net income and taxes might be lower.
But LIFO is not a good indicator of ending inventory value as it understates the value of inventory, since actual flow of goods does not match cost of goods sold in the books.
Should you use LIFO to manage inventory?
FIFO would be impractical in inventory management as it understates the value of inventory. Plus, using FIFO would mean the oldest inventory would constantly be ignored and gradually keep shifting to the back of the warehouse. That would eventually make it obsolete making it worthless later on. This would lead to a total waste of the capital tied up in the older items, and decreasing cash flow to a huge extent.
LIFO vs. FIFO
Now that you know what the two inventory accounting methods are about, let’s see which one is actually better for your business according to the following factors.
It is sensible to sell items according to the FIFO since it maintains a balance between older and newer being sold. Most business use the FIFO method to sell stock. In LIFO, the older inventory becomes obsolete and prone to wastage or disposal. Fewer business use the LIFO method.
Inflation and Deflation
During FIFO, the oldest items sold are the least expensive. Therefore, cost of goods sold(COGS) will decrease and profits will be comparatively higher. This will result in paying higher income tax. In LIFO, the newest items are the most expensive. So COGS will be lower, profits will be lower and thus, income taxes to be paid will also be lower.
While prices are dropping (deflation), in FIFO, and LIFO, the situation is exactly reversed.
Inventory management and accounting
Inventory management and record keeping is easier in FIFO since the number of inventory layers is reduced as the older items are used up timely. FIFO also makes warehouse management easier since any kind of inventory isn’t constantly pushed at the back and there is reduced wastage.
On the other hand, in LIFO, there are too many inventory layers created as oldest inventory is continuously pushed back to make room for new stock. This makes inventory management more complex.
In general, LIFO is not as recommended since the value of inventory is greatly distorted at the end of the accounting term. It has been banned by the IFRS and only companies in the U.S can use it. The numerous inventory layers created under LIFO make it difficult to track and count inventory as compared to FIFO. the only time where LIFO can be used is during inflation, to reduce taxable income.