Last In, First Out LIFO Inventory Method Explained

LIFO is used to calculate inventory value when the inventory production or acquisition costs substantially increase year after year, due to inflation or otherwise. Even though this method demonstrates a drop in company profits, it helps with tax savings due to higher inventory write-offs. The FIFO method is the more common and trusted method compared to LIFO, since it offers few discrepancies when calculating inventory’s value. However, LIFO is sometimes used when businesses are prone to higher COGS and lower profit margins.

How To Calculate FIFO

Having a single source of accurate supply chain analytics and data is critical to ensuring the financial well-being of your ecommerce business. Another benefit of FIFO is that you’re able to track and regulate quality and offset the risk of high holding costs for storing dead stock. US companies may choose between the LIFO or the FIFO method (there are other methods too, but for now, we’ll focus on the comparison of these two).

LIFO: The Last In First Out Inventory Method

LIFO (“Last-In, First-Out”) means that the cost of a company’s most recent inventory is used instead. In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income. Since LIFO expenses the newest costs, there is better matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost. The total cost of goods sold for the sale of 350 units would be $1,700.

1. The remaining unsold 450 would remain on the balance sheet as inventory for $1,275.
2. What happens during inflationary times, and by rising COGS, it would reduce not only the operating profits but also the tax payment.
3. That only occurs when inflation is a factor, but governments still don’t like it.
4. Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times.
5. Jordan operates an online furniture company that holds luxury furniture inventory in a large warehouse.

Pharmaceutical products tend to experience high inflation in prices. Thus, it is most accurate for them to report based on the most recent prices of their inventory purchases. Therefore, the oldest costs are the ones that remain on the balance sheet while the most recent ones are expensed first. LIFO, or Last In, First Out, is an inventory value method that assumes that the goods bought most recently are the first to be sold. When calculating inventory and Cost of Goods Sold using LIFO, you use the price of the newest goods in your calculations. To calculate FIFO, multiply the amount of units sold by the cost of your oldest inventory.

Below, we’ll dive deeper into LIFO method to help you decide if it makes sense for your small business. Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times. By offsetting sales income with their highest purchase prices, they produce less taxable income on paper. Under LIFO, the company reported a lower gross profit even though the sales price was the same. Now, it may seem counterintuitive for a company to underreport profits. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax.

Here, we are assuming the company has not sold any product yet. Please note how increasing/decreasing inventory prices through time can affect the inventory value. There are three other valuation methods that small businesses typically use.

How SKU Tracking Can Help Your Business

It looks like Lee picked a bad time to get into the lamp business. The costs of buying lamps for his inventory went up dramatically during the fall, as demonstrated under ‘price paid’ per lamp in November and December. So, Lee decides to use the LIFO method, which means he will use the price it cost him to buy lamps in December.

But in some cases, it can make your business look more profitable or be a better representation of how your business operates. Michelle Payne has 15 years of experience as a Certified Public Accountant with a strong background in audit, tax, and consulting services. She has more than five years of experience working with non-profit organizations in a finance capacity. Keep up with Michelle’s CPA career — and ultramarathoning endeavors — on LinkedIn. As with FIFO, if the price to acquire the products in inventory fluctuates during the specific time period you are calculating COGS for, that has to be taken into account. Let’s say on January 1st of the new year, Lee wants to calculate the cost of goods sold in the previous year.

Which financial ratios does LIFO ending inventory calculation affect?

CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. FIFO and LIFO are helpful tools for calculating the value of your business’s inventory and Cost of Goods Sold. FIFO assumes that your oldest goods are sold first, while LIFO assumes that your newest bottom up forecasting goods are sold first. The FIFO (“First-In, First-Out”) method means that the cost of a company’s oldest inventory is used in the COGS (Cost of Goods Sold) calculation.

To make the best decision for your business, it’s important to consult your CPA. If the manufacturing plant were to sell 10 units, under the LIFO method it would be assumed that part of the most recently produced inventory from Batch 2 was sold. The inventory process at the end of a year determines cost of goods sold (COGS) for a business, which will be included on your business tax return. COGS is deducted from your gross receipts (before expenses) to figure your gross profit for the year. FIFO is more common, however, because it’s an internationally-approved accounting methos and businesses generally want to sell oldest inventory first before bringing in new stock.

Your financial statements and tax return must be consistent and use the same method. But if your inventory costs are decreasing over time, using the LIFO method will mean counting the cheapest inventory first. Your Cost of Goods Sold would be lower and your net income will be higher. Your leftover inventory automated expense management software will be your oldest, more expensive stock meaning a higher inventory value on your balance sheet.

This article will cover how to determine ending inventory by LIFO after selling in contrast to the FIFO method, which you can discover in Omni’s FIFO calculator. Also, we will see how to calculate its cost of goods sold using LIFO, and show how to use our LIFO calculator online to make more profits. Last In, First Out is a method of inventory valuation where you assume you sold your newest inventory first. This is the opposite of the most common method, First In, First Out (FIFO).

However, the main reason for discontinuing the use of LIFO under IFRS and ASPE is the use of outdated information on the balance sheet. Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements. For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators.

To determine the cost of units sold, under LIFO accounting, you start with the assumption that you have sold the most recent (last items) produced first and work backward. LIFO might be a good option if you operate in the U.S. and the costs of your inventory are increasing or are likely to go up in the future. By using this method, you’ll assume the most recently produced or purchased items were sold first, resulting in higher costs and lower profits, all while reducing your tax liability. LIFO is often used by gas and oil companies, retailers and car dealerships. Under IFRS and ASPE, the use of the last-in, first-out method is prohibited. However, under GAAP, the use of Last-In First-Out is permitted.