What is 'Last In, First Out - LIFO'
Last in, first out (LIFO) is an asset management and valuation method that assumes assets produced or acquired last are the ones used, sold or disposed of first; LIFO assumes an entity sells, uses or disposes of its newest inventory first. If an asset is sold for less than it is acquired, then the difference is considered a capital loss. If an asset is sold for more than it is acquired, the difference is considered a capital gain.
BREAKING DOWN 'Last In, First Out - LIFO'
Using the LIFO method to evaluate and manage inventory can be tax advantageous, but it may also increase tax liability. The world of accounting is full of inventory management conventions used to help keep track of the cost and value of inventory. For this, accountants have developed two systems of inventory management: first in, first out (FIFO) and last in, first out (LIFO).
LIFO vs. FIFO
FIFO assumes the first inventory in is the first inventory sold. Grocery stores and retail outlets with perishable goods generally operate in this fashion to prevent obsolescence. LIFO is based on moving the last inventory in out first. In general, companies select the system most favorable to their tax and income situation.
LIFO vs. FIFO Example
Assume 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 one day ago. Based on the LIFO method of inventory management, the last widgets in are the first ones to be sold. Seven widgets are sold, but how much can the accountant record as a cost?
Each widget has the same sales price so revenue is the same, but the cost of the widgets is based on the inventory method selected. Based on the LIFO method, the last inventory in is the first inventory sold. This means the widgets that cost $200 sold first. The company then sold two more of the $100 widgets. In total, the company sold $1,200 worth of widgets under the LIFO method, or five at $200 and two at $100. This is in contrast to FIFO, which means the $100 widgets are sold first, followed by the $200 widgets. Using the FIFO method, the company sold $900 worth of widgets, or five at $100 and two at $200. This is why in periods of rising prices, LIFO creates higher costs and lowers net income, which also lowers taxable income. Likewise, in periods of falling prices, LIFO creates lower costs and increases net income, which also increases taxable income.