What is Last In, First Out?
Last in, first out (LIFO) is a method used to account for inventory, where the most recently produced items are recorded as sold first. Under LIFO, the cost of the most recent products purchased (or produced) are the first to be expensed as cost of goods sold (COGS) – which means the lower cost of older products will be reported as inventory. Two alternative methods inventory-costing are 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 units available for sale during the accounting period and then uses that average cost to determine COGS and ending inventory.
Understanding Last In, First Out (LIFO)
Last in, first out (LIFO) is only used in the United States where all three inventory-costing methods can be used under generally accepted accounting principles (GAAP) because International Financial Reporting Standards forbids the use of the LIFO method. The companies that use LIFO inventory valuations are typically those with relatively large inventories, such as retailers or auto dealerships, that can take advantage of lower taxes — when prices are rising — and higher cash flows. Many U.S. companies prefer to use FIFO though, because if a firm uses LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to shareholders, which lowers net income and, ultimately, earnings per share.
LIFO, Inflation and Net Income
When there is zero inflation, all three inventory-costing methods produce the same result. But if inflation is high, the choice of accounting method can dramatically affect valuation ratios:
- FIFO provides a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value COGS. Increasing net income sounds good, but it can increase the taxes that a company must pay.
- LIFO is not a good indicator of ending inventory value, because it may understate the value of inventory. LIFO results in lower net income (and taxes) because COGS is higher. However, there are fewer inventory write-downs under LIFO during inflation.
- Average cost produces results that fall somewhere between FIFO and LIFO.
(Note: if prices are decreasing, then the complete opposite of the above is true.)
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 cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100. In contrast, using FIFO, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, 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.