Imagine this scenario:
Jordan operates an online furniture company that holds luxury furniture inventory in a large warehouse.
Recently, Jordan purchased 20 sofas at $1,500 each and six months later, another 20 units of the same sofa at $1,700 each.
To calculate ending inventory value, Jordan took into account the cost of the latest inventory purchase at $1,700, despite the newer inventory still being on hand.
This might seem backwards to most businesses, but Jordan uses LIFO, an inventory valuation method that is less common but is legal in the US.
When Jordan opened the business, he decided that LIFO made the most sense. But that’s not to say it’s beneficial for all businesses.
LIFO, like other inventory valuation methods, has advantages and disadvantages.
When is LIFO used? What are its pros and cons? How does it differ from other methods? In this article, we break down what the LIFO method entails, how it works, and its use cases.
What is LIFO?
LIFO, which stands for last in, first out, is an inventory valuation method that uses the cost of the most recent products purchased to calculate the cost of goods sold (COGS), while older inventory value is considered ending inventory on a balance sheet.
Though LIFO is accepted under the Generally Accepted Accounting Principles (GAAP), unlike the more common valuation methods, such as FIFO or weighted average cost, the International Financial Reporting Standards (IFRS) forbids the use of the LIFO method.
How the last in, first out method of inventory management works
The LIFO method assumes that the most recently purchased inventory items are the ones that are sold first.
With this cash flow assumption, the costs of the last items purchased or produced are the first to be counted as COGS. Meanwhile, the cost of the older items not yet sold will be reported as unsold inventory.
To further understand how LIFO works, let’s imagine a vitamin and supplement brand that secured 3 batches of the same supplement over a course of 3 weeks.
|Batch 1||10||Week 1|
|Batch 2||20||Week 2|
|Batch 3||40||Week 3|
In week 4, a customer placed an order for 25 of these supplement bottles.
As per LIFO, the business dispatches 25 units from Batch 3 (the newest inventory) to the customer.
This brings the ending inventory balance in the warehouse to:
Though LIFO is considered an inventory management process, it’s important to keep in mind that calculating inventory value doesn’t always follow the actual flow of inventory from being received to being sold.
However, for accounting purposes, as long as you remove COGS from the last inventory replenishment cycle under LIFO, it (technically) doesn’t matter if you sell the oldest or latest inventory items first.
To understand further how LIFO is calculated despite real inventory activity, let’s dive into a few more examples.
Examples of calculating inventory using LIFO
Let’s imagine a stationery supplier, who has 300 units of pens in stock, purchased these in 3 batches of 100 units each. The cost of the first batch was $1 each unit. Due to inflation, the next two batches cost $2 each and $3 each unit, respectively.
|Batch||Unit count||Cost per unit||Total cost|
Then, this supplier sells 200 pens. With LIFO, the inventory purchased in Batch 3 and then Batch 2 are assumed to have sold first, while Batch 1 still remains on hand.
To calculate COGS, it would take into account the newest purchase prices.
COGS = (The Number of Newest Units x Their Value) + (Remaining Units From the Second Purchase x Their Value)
COGS = (100 x $3) + (100 x $2) = $500
Meanwhile, items of Batch 1 are considered unsold.
The ending inventory value reported would be:
Ending Inventory Value = Remaining Units x Their Value
Ending Inventory Value = 100 x $1 = $100
Consider another example of a fictitious manufacturing plant, ABC Ltd, that produced 2 batches of the same SKU with the following specifications:
|Batch||Unit count||Cost per unit||Total cost|
If the manufacturing plant were to sell 10 units, under the LIFO method it would be assumed that part of the most recently produced inventory from Batch 2 was sold. So, the COGS will be a total cost of 10 units at $30 each.
COGS = The Number of Newest Units x Their Value
COGS = 10 x $30 = $300
The ending inventory value is then calculated by adding the value of Batch 1 and the remaining units of Batch 2.
Ending Inventory Value = Remaining Units x Their Value
Ending Inventory Value = (5 x $20) + (20 x $30) = $700
LIFO vs FIFO
US companies may choose between the LIFO or the FIFO method (there are other methods too, but for now, we’ll focus on the comparison of these two).
Though both are legal to use in the United States, LIFO is considered to be more complex and is less favored. Ideally, LIFO is used when a business’s COGS tend to be higher and profits are lower. When this is the case, a business using LIFO will pay less in taxes.
Here is a quick overview of the differences between the two inventory accounting practices:
|LIFO method||FIFO method|
|Stands for “Last-In, First-Out”||Stands for “First-In, First-Out”|
|Assumes the latest inventory units are sold first||Assumes the oldest inventory units are sold first|
|Is especially useful during inflation, as it results in lower net income as compared to FIFO||Is not as useful during inflation, as it results in higher net income as compared to LIFO|
|Can only be used in the US, since it is banned by the IFRS||Can be used by global businesses since its approved by the IFRS|
|Not recommended for perishable or time-sensitive goods||Can be used for all kinds of goods, but provides a dual advantage when selling items prone to going obsolete quickly or obtain an expiry date|
|Understates the value of ending inventory||More accurately values ending inventory|
|Not a commonly used method since the accounting process is more complex and is often linked to manipulating income to secure unfair tax benefits||Is usually the most widely used and accurate accounting method, since the flow of costs and goods are often aligned|
What method of inventory management should you use?
When prices are rising, it can be beneficial for companies to use LIFO since COGS associated with its newest inventory is accounted for, rather than older inventory. Many companies that hold large quantities of high-priced inventory may use LIFO (such as a furniture store or an auto dealership).
Every business deals with price increases, inflation, and holding inventory that loses its value over time, but LIFO is ideal for businesses that carry pricier inventory that tend to lose its value substantially year after year.
That’s why auto dealerships are a great example of why LIFO is used; the moment a new car is driven, it loses value. But that’s not to say used cars are not in high demand.
However, if an auto dealership used FIFO rather than LIFO, it would most likely showcase major discrepancies in ending inventory value.
If you consider the typical online business, LIFO isn’t widely used. The biggest criticism that LIFO faces is the claim that it distorts inventory value on a balance sheet in times of high inflation. Critics of this method also point out that LIFO offers an unfair tax break, since it provides a higher tax cut.
That’s why, for most online brands especially, the FIFO method is most commonly used, as it makes calculating inventory value much easier and often matches the natural flow of inventory throughout an ecommerce supply chain.
Another benefit of FIFO is that you’re able to track and regulate quality and offset the risk of high holding costs for storing dead stock.
But that’s not to say LIFO might not make sense for your business. If you’re considering LIFO, be sure to have a conversation with your CPA. You will also need to follow a process to legally switch to LIFO.
How to switch to LIFO
To use the LIFO method, you will need permission from the IRS to switch from the default FIFO (or any other method) to the LIFO method.
To elect for the LIFO inventory accounting method, you must fill in and submit Form 970, along with your tax returns in the year you first implemented LIFO. It’s best to consult your CPA throughout this process.
Within your application, make sure to include:
- The inventory items on which LIFO will be applied
- Description of the inventory valuation method(s) used in the previous year for the same goods
- The inventory items on which LIFO will not be applied
Note: Once you switch to LIFO (or decide on any method), you cannot switch methods in the middle of an accounting period or fiscal year. If you do switch to the LIFO method but want to revert back to using the FIFO method, you will need approval from the IRS.
Leave inventory management to the pros
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Here are answers to the most common questions about the LIFO inventory method.
Is LIFO better than FIFO?
The FIFO method is the more common and trusted method compared to LIFO, since it offers few discrepancies when calculating inventory’s value. However, LIFO is sometimes used when businesses are prone to higher COGS and lower profit margins. To make the best decision for your business, it’s important to consult your CPA.
Is LIFO legal?
LIFO is legal in the US, but since it is banned by the IFRS, a globally accepted accounting standard, global businesses or businesses that operate outside the US cannot legally use LIFO.
In what cases is LIFO used?
LIFO is used to calculate inventory value when the inventory production or acquisition costs substantially increase year after year, due to inflation or otherwise. Even though this method demonstrates a drop in company profits, it helps with tax savings due to higher inventory write-offs.