What Is LIFO? (With Steps to Use It and an Example)
By Indeed Editorial Team
Published May 31, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When processing the accounts for a company, one factor to consider is the cost of the goods sold, which can differ over time. It may be important to know which products sold first, and the concept of LIFO can help with this process. Understanding the LIFO inventory method and its importance can help you decide on the best inventory cost method to use.
In this article, we answer the question, "What is LIFO?", discuss its uses, explore its effects, understand its challenges, read tips to consider when using LIFO, provide the definition of FIFO, learn the differences between LIFO and FIFO, and provide an example of LIFO.
What is LIFO?
If you are interested in inventory management, you might be wondering, "What is LIFO?". LIFO, or last in, first out, is a method that you can use to account for inventory. This method speculates or records the most recently produced items as the first that sell at the start of an accounting year. When calculating the cost of products, this system involves looking at the ones most recently added to the inventory. Companies usually use the LIFO inventory management system for products that are non-perishable or have a low turnover rate.
Companies use LIFO to determine inventory costs, which can significantly affect financial statements, including the balance sheet, income statement, and statement of cash flows. It's also helpful in valuing the available inventory at the end of a determined period and the cost of goods during that period.
Why do companies use LIFO?
Companies use the LIFO inventory method when the cost of buying inventory or making products grows due to factors like inflation. By lowering the net income, LIFO allows the company to pay less corporate tax, even though it can lead to a decline in the company's profits. It can also help the company increase its savings if its inventory and production costs continue to grow.
You can only use LIFO in certain market conditions, as companies typically avoid this method when prices are steady. The LIFO bookkeeping process is quite complex as some of the company's older products can stay in the inventory. It's also important to remember that the cost of goods sold can be a false representation of the company's physical inventory.
Effects of LIFO
Companies that use LIFO base their decision on the assumption that the cost of their inventory increases over time. This is a reasonable assumption in times of inflation. Accountants using this inventory method may determine that the cost of the most recently bought inventory is higher than the cost of the previously bought inventory. This means the system values the ending inventory balance at earlier prices, while the newest costs come under the cost of goods sold (COGS).
COGS refers to all expenses related to producing a business's products and is the value of all inventory sold within a given period. Shifting high-cost inventory into COGS allows a company to reduce its reported level of profitability, deferring its recognition of income taxes.
Challenges of LIFO
LIFO can be an unrealistic inventory system and challenging to maintain. This accounting method can result in a lot of unused older inventory that the company never sells. This is because the LIFO method insists on using the newest purchases or inventory as the cost of goods sold. LIFO involves more complex record keeping because these inventory costs always remain in the accounting system. If the company plans to expand internationally, using LIFO is best avoided because many international accounting standards don't allow for LIFO valuation.
Tips to consider when choosing the LIFO method
Here are some tips to consider when choosing the LIFO inventory method:
Consider your options
It's important to ensure that the LIFO inventory method is the best option before deciding on it. While LIFO is a more complicated process, it can increase a company's savings. You can consult with a business tax professional before making this decision.
Examine the type of business
For companies that deal with perishable products, the LIFO inventory method can be challenging to use as it leaves older products in stock. This can lead to spoiling and overall product loss. This applies to car part suppliers and food companies. When doing the accounting for a company, it's best to consider the company's products to determine if the LIFO inventory method works for them.
What is FIFO?
FIFO stands for first in, first out, and assumes that the company sells its older inventory first. Companies that sell perishable products or goods that can go obsolete typically use the FIFO inventory valuation method to prevent their old goods from spoiling and increasing loss.
Accountants usually consider FIFO more profitable because of the fluctuations of the economy and the risk that the cost of producing goods can rise over time. It's ideal for impressing investors but has a higher tax liability. FIFO leads to lower recorded costs per unit, but records a higher level of pre-tax earnings. Typically, these companies are likely to deal with higher taxes with higher record profits.
What's the difference between LIFO and FIFO?
You can differentiate the LIFO and FIFO method based on two factors, which are inflation and the valuation of inventory and its impact on the COGS and profits:
Inventory valuation and impact on the COGS and profits
The LIFO inventory method uses the most recently bought inventory to value the cost of goods sold. This can lead to the leftover inventory becoming exceedingly old or obsolete. The LIFO inventory method may provide an inaccurate inventory value, as the valuation can be lower than the inventory items in the current market.
This method is also impractical for companies that typically avoid leaving their older inventory in stock while using the most recently bought inventory. An example is when a company specializes in perishable products, like seafood, as they are more likely to get the old stock out first.
The FIFO inventory method better indicates the value of ending inventory as companies use the older inventory first, while the more recent inventory reflects the current market prices. Most companies and accountants prefer this inventory method, as businesses usually use their older inventory first in producing goods. This method seems more logical, and it also means the valuation of the COGS portrays their production schedule.
When using the LIFO inventory method to record sales, you use the newest inventory items to value the COGS, and you sell these items before the older, lower-priced inventory. With inflation, the current COGS is greater under LIFO because new inventory is more expensive, while the company's net income and profit for the period is lower. An advantage of the lower profit or earnings is that the company can gain from reduced tax liability.
When you record sales using the FIFO method, it means that the goods that you purchased first, which are the older inventory, are the goods that you deplete first. Using FIFO in inflation keeps the more recent and expensive inventory on the balance sheet. Meanwhile, FIFO can increase your net income by using inventory that's many years old and that you bought at a reduced cost. An increased net income implies an increased tax liability for the business.
Example of LIFO
Below is an example of using the LIFO inventory method:
Angela started a shoe business, but the price of the goods that she uses to produce the shoes has significantly increased. Angela decided to apply the LIFO inventory method to her business. That means she can use the recent price she paid for the supplies in her calculation. Her COGS calculation looks like this:
Number of goods × cost of each good = COGS
Angela bought 65 items and they each cost $400
65 × $400 = $26,000
As Angela knows that the price of shoe production supplies can increase, she can get a tax break by calculating her COGS with this lower number. If she expects the price to increase during the next month, this lower number can help her company pay less tax. This can increase her savings but also decrease her company's profits. A business like Angela's can use this inventory method because it sells non-perishable products that it can keep for a long time.
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