What it means
Last-In, First-Out, commonly known as LIFO, is a way for businesses to track the cost of the goods they sell. Under this method, the accounting system assumes that the most recent inventory purchases are the first ones used to fulfil customer orders.
This means the older inventory stays on the balance sheet for a longer period. Why does this matter?
During periods of rising prices, using LIFO means your cost of goods sold is higher because you are recording the most expensive items. A higher cost of goods sold reduces your taxable profit, which can save a business money on taxes in the short term.
However, it can make your balance sheet look less healthy because the inventory value is outdated. It is widely used in retail, manufacturing, and wholesale sectors where prices fluctuate frequently.
Managers must weigh the immediate tax advantages against the administrative burden of tracking purchases meticulously. It is worth noting that international accounting standards prohibit LIFO, so it is primarily used in the United States under standard rules.
For non-finance managers, understanding LIFO helps explain why profitability figures might look lower during inflationary periods even when sales volumes are strong. It directly impacts your profit and loss statement and influences how much cash you have available for reinvestment.
In practice
Real-world examples.
Example
A boutique coffee shop buys coffee beans at 10 pounds per bag, then later at 12 pounds per bag. Under LIFO, when a customer buys a bag, the shop records the cost as 12 pounds, matching the latest purchase price.
Example
A small hardware store purchases 100 heaters at 30 pounds each, and later another 100 at 35 pounds each. Selling 50 heaters means using the 35 pound cost, leaving the older, cheaper stock on the balance sheet.
Example
An electronic parts distributor buys computer chips at 5 pounds, then price rises to 7 pounds. Selling 1,000 chips means recording the cost at 7 pounds each, reducing taxable income during price spikes.
Think of it
“Imagine a stack of plates where you always place new plates on top and take plates off the top to use. The plate you added last is the very first one you use.
Formula
Calculation
Cost of Goods Sold = Ending Inventory Value subtracted from the sum of Beginning Inventory plus Purchases. Example: Beginning stock is 1,000 pounds, new purchases total 3,000 pounds. Ending stock valued at oldest prices is 800 pounds. Cost of Goods Sold = (1,000 + 3,000) - 800 = 3,200 pounds.Case study
Seen in the real world.
Oak Furniture Ltd, a growing furniture retailer, experienced rising timber prices over the year. At the start of the year, basic dining tables cost 150 pounds to manufacture. By December, due to supply chain pressures, the manufacturing cost rose to 200 pounds per table. During December, Oak Furniture sold 500 tables. Using the LIFO method, the company recorded the cost of these 500 tables at the newer, higher price of 200 pounds each, resulting in a total cost of goods sold of 100,000 pounds instead of the 75,000 pounds it would have been using the older costs. This higher expense reduced their taxable profit for the year by 25,000 pounds, preserving crucial cash flow for the business during a period of inflation. However, the tables remaining in the warehouse were officially valued on the balance sheet at the older, lower price of 150 pounds, meaning the inventory asset value did not reflect current market replacement costs.
Watch out
Common mistakes.
- Assuming LIFO reflects the actual physical movement of goods, whereas it is only an accounting assumption.
- Forgetting that LIFO is not allowed under international financial reporting standards.
- Failing to realise that low inventory values on the balance sheet can mislead lenders regarding asset strength.
Questions
People also ask.
Do I have to physically ship the newest items first if I use LIFO?
No. LIFO is strictly an accounting method for calculating costs, not a rule for how you physically store or move your inventory.
Why would any company choose LIFO?
Companies choose LIFO primarily to reduce their tax burden during periods of inflation by matching higher recent costs with current revenues.
Is LIFO used everywhere in the world?
No. It is common in the United States, but it is banned under International Financial Reporting Standards used across Europe and many other regions.
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