What Is the Last-In, First-Out (LIFO) Method?

Definition of the LIFO Method of Inventory Valuation

The last in, first out method records the last (most recent) items to be added to the inventory as the first to be sold. This method assumes that the latest inventory items are the ones most likely to be sold, leaving older items in stock. U.S. companies frequently use the LIFO method of inventory cost accounting as a way to lower their businesses’ reported incomes and tax liabilities, especially during times of high inflation.

LIFO Inventory Method Formula

The LIFO method formula is not a formula but rather a technique you can use to account for your business inventory’s cost. The key feature of the LIFO method is the fact that the most recent items added to your inventory are the first ones to be recorded as sold when a customer makes a purchase.

Here is a step by step breakdown of how to use the LIFO method for inventory costing:

1. Establish a convenient way to track your business’s transactions, including the date of each purchase and the quantity and cost of each item.
2. Each time a sale occurs, calculate the cost of goods sold based on the cost of the most recently acquired inventory item of the same type.
3. Adjust your remaining inventory balance by removing the total value of the sold units, again based on the value of the most recently acquired items of the same types.
4. Each time new inventory is acquired, update your records by adding the cost of the newly acquired items to your total inventory value.
5. These most recent acquisitions are now the new basis for calculating the value of items sold (until the next acquisition of that type of item).
6. At the end of the financial reporting period, calculate your ending inventory value based on the cost of the oldest inventory items of each type still on hand.
7. Calculate your net purchase value by adding up the values of all the sales you recorded during the period.
8. Calculate your cost of goods sold (COGS) for the period by plugging your beginning inventory value, net purchase value, and ending inventory value into the COGS formula:

COGS = beginning inventory value + net purchases value – ending inventory value

Examples of LIFO

Let's look at a more practical example. Suppose your business’s inventory has a value of $10,000 at the beginning of the financial reporting period. Throughout the period, you record a total of $30,000 in sales (based on the value of the most recently acquired inventory items at the time of each sale). At the end of the period, you add up the total value of all the items currently in your business’s inventory (based on the value of the oldest items still in your inventory) and arrive at $15,000.

• Your beginning inventory value is $10,000
• Your net purchases value is $30,000
• Your ending inventory value is $15,000

You would then plug those values into the COGS formula:

$10,000 + $30,000 - $15,000 = $25,000

This means that your LIFO cost of goods sold for the period is $25,000.

How to Use LIFO to Your Advantage

Here are a couple of the major benefits of using the LIFO method of inventory accounting:

1. Tax Benefits

Usually, the main advantage of the LIFO method is its potential tax benefits. When prices are on the rise, using the LIFO method to do your inventory costing can result in a lower reported income for your business — which means a lower taxable income, too. This decrease in reported income happens because the COGS you’re reporting is based only on your products’ highest possible values.

2. More Accurate Revenue/Cost Matching

LIFO is sometimes considered to be more accurate than other inventory costing methods when it comes to matching current costs with current revenues. When prices are rising rapidly, using the LIFO method can help to reflect increasing inventory costs in your cost of goods sold, allowing for a more accurate representation of profitability.

Alternatives to the LIFO Inventory Costing Method

While the LIFO method has its advantages, there are also certain scenarios in which it’s not the best option. When choosing whether or not to use the LIFO method for your business, it’s very important to weigh the benefits against the potential drawbacks.

1. Inaccurate Financial Reporting

The LIFO method can sometimes result in inventory valuations that do not reflect the actual inventory replenishment cost of a business’s inventory. This discrepancy can cause the overall value of the company’s assets to become understated.

2. Administrative Complexity

Additionally, the LIFO method is simply more complicated than other inventory accounting methods. Tracking the specific costs associated with the most recent inventory purchases requires meticulous recordkeeping, and even small changes in inventory levels can impact financial statements in significant ways.

If you're concerned about these drawbacks for your business, consider alternative inventory costing methods like the first in, first out (FIFO) method or the average cost method.

• First In, First Out Method: FIFO cost accounting is the opposite of LIFO cost accounting. It assumes that your business is selling the oldest items in its inventory first. Using this method instead of the LIFO method during inflationary periods will typically result in a higher reported income.
• Average Cost Method: The average cost method calculates the cost of goods sold based on the average value of all units of that type in your inventory during the reporting period. It aims for a healthy balance between LIFO and FIFO and is typically preferred in situations where inventory turnover is high.

Keep in mind that in the United States, any of these three inventory accounting methods are permissible under the Generally Accepted Accounting Principles (GAAP). However, in many other parts of the world, last in, first out accounting is illegal because of the way it intentionally minimizes taxable income.

Simplify Your Inventory Management

If you’re using the LIFO method, an efficient, automated way to count your inventory in real-time is a must. Zupan’s integrated, AI-powered inventory management solution is the perfect tool to help you keep diligent track of every change to your business’s inventory, hassle-free.