LIFO (Last In, First Out)
What is LIFO?
LIFO, or “Last In, First Out,” is a method of inventory management and accounting where the last items added to an inventory are recorded as the first to be sold.
FIFO (first in, first out) - which is the exact opposite of LIFO - is the default method of inventory accounting. However, in the United States businesses can choose to elect the LIFO option if they wish.
What is the LIFO method?
The LIFO method assumes that the most recently purchased or produced goods will be sold first. Imagine a supermarket shelf with apples. Every day, a clerk adds apples to the top of the pile, while customers keep choosing those same apples, rather than the apples at the bottom.
Now, let’s say that a case of the older apples were bought last week for $15, while this week, a case of the newer apples cost $20. Based on the LIFO method, you’ll assume that the newer, more expensive apples were sold first, and expense them as Cost of Goods Sold (COGS). Then, the older, less costly case of apples will be reported as inventory.
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Why is LIFO important?
LIFO is a strategic method of doing accounting for companies with large supplies of inventory, such as retailers. There are several advantages and disadvantages to using it.
This method usually allows a business to save money by reporting a lower inventory value, and therefore paying less taxes. For example, in the above case, a business would report their inventory value at $15 per case of apples, report a lower net income, and in conclusion pay a smaller percentage of taxes. However, when prices fall, LIFO overestimates the net income since cheaper, newer inventory is used in the COGS calculation—resulting in a higher tax bill and higher net income.
A disadvantage of LIFO is that net income is typically reported at a lower value. And then, when calculating measurements such as profit margin, the financial health of a business will appear less impressive. The same goes with showing earnings to investors.
The decision to elect the LIFO or FIFO method is up to the business. Yet, it’s certainly worth consulting with a tax professional. This is because once the LIFO method is chosen, they must stick to it whether the cards are in their favor or not.