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However, it can make your balance sheet look less healthy because the inventory value is outdated.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.
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.
In practice
Real-world examples
Example 1
A boutique coffee shop buys coffee beans at $10 per bag, then later at $12 per bag. Under LIFO, when a customer buys a bag, the shop records the cost as $12, matching the latest purchase price. The oldest $10 bags stay on the balance sheet until stock levels drop.
Example 2
A small hardware store purchases 100 heaters at $30 each, and later another 100 at $35 each. Selling 50 heaters means using the $35 cost, so the cost of goods sold is $1,750 and the older, cheaper stock stays on the balance sheet. A FIFO calculation would give only $1,500 for the same sale.
Example 3
An electronic parts distributor buys computer chips at $5, then the price rises to $7. Selling 1,000 chips means recording the cost at $7 each, which is $7,000 instead of $5,000. The extra $2,000 of expense reduces 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 = Beginning Inventory + Purchases - Ending Inventory.
Example: beginning stock is $1,000 and new purchases total $3,000. Ending stock valued at the oldest prices is $800. Cost of Goods Sold = ($1,000 + $3,000) - $800 = $3,200.
Here is the layered method. A shop holds 100 units bought at $10 and then buys 100 units at $12, so $2,200 of goods are available. It sells 120 units. LIFO takes the newest layer first: 100 units x $12 = $1,200, plus 20 units x $10 = $200, giving cost of goods sold of $1,400. The 80 units left are valued at the older $10 cost, so ending inventory is $800, and $1,400 + $800 = $2,200 confirms the arithmetic.
Under first-in, first-out the same sale would cost 100 x $10 + 20 x $12 = $1,240. LIFO therefore reports $160 more expense, and if the tax rate were 25% that would cut the tax bill by $40.Case study
Seen in the real world
This is a fictional, illustrative scenario. 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 to manufacture. By December, due to supply chain pressures, the manufacturing cost rose to $200 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 each, resulting in a total cost of goods sold of $100,000 instead of the $75,000 it would have been using the older costs. This higher expense reduced their taxable profit for the year by $25,000, 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, meaning the inventory asset value did not reflect current market replacement costs. The finance manager explained this gap to the bank so lenders would not misread the lower inventory figure as a sign of weakness.
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.