LIFO inventory method

What is Last In First Out?

The LIFO inventory method, or Last-In, First-Out, is an inventory valuation technique used to track and value the inventory. It assumes that the most recently acquired inventory is the first to be sold or used, while older inventory remains on the stock records.

In other words, under Last In First Out, the cost of goods sold (COGS) is based on the most recent purchases, resulting in higher COGS and potentially lower profits during periods of rising prices. LIFO can be beneficial for businesses looking to minimize taxable income, manage cash flow, or accurately reflect the current cost of inventory during the inflation period.

A practical example of the LIFO method

The store purchases laptops from various suppliers at different prices throughout the year. Using the Last In First Out method, we will calculate the inventory and costs of goods sold in the following table.

Purchase Date	Quantity Purchased	Cost per Unit (in $)
Jan 1, 2023	50	400.00
Mar 15, 2023	30	420.00
Jun 10, 2023	20	450.00
Sep 5, 2023	40	480.00

Let’s assume that during the year, the store sold 110 laptops. Now, using the Last In First Out method, we calculate the COGS based on the last purchases:

1. First, we sell the 40 units purchased on Sep 5, 2023, for $480 per unit, resulting in a COGS of $19,200.
2. Next, we sell 20 units from the purchase made on Jun 10, 2023, for $450 per unit, resulting in a COGS of $9,000.
3. Next, we sell 30 units from the purchase made on Mar 15, 2023, for $420 per unit, resulting in a COGS of $12,600.
4. Finally, we sell the remaining 20 units from the purchase made on Jan 1, 2023, for $400 per unit, resulting in a COGS of $8,000.

The total COGS for the year using the LIFO method would be $48,800.

Effects of LIFO in net income, COGS, and Tax During Inflation

During inflation, the Last In First Out method has a specific impact on net income, cost of goods sold (COGS), and tax. LIFO tends to result in lower net income and tax because the most recent, higher-priced inventory is used to calculate the cost of goods sold or the cost of goods manufactured. Consequently, COGS increases, reducing gross profit and net income.

This lower net income leads to a lower taxable income, resulting in potential tax savings. By matching higher costs with revenue, Last In First Out reflects the impact of inflation more accurately. It is important to note that the specific impact on net income, COGS, and tax will depend on the business’ inventory turnover and pricing dynamics.

Effects of LIFO in net income, COGS, and Tax During Deflation

During deflation, the Last In First Out method has specific effects on net income, cost of goods sold (COGS), and tax. Last In First Out tends to result in higher net income because the oldest, lower-priced inventory is used to calculate the cost of goods sold or the cost of goods manufactured.

Consequently, COGS decreases, increasing gross profit and net income. This higher net income leads to higher taxable income, potentially resulting in increased tax liabilities. Since Last In First Out assumes the most recent inventory is sold first, it may not accurately reflect the impact of deflation on inventory costs.

Why LIFO is not allowed in most of the countries?

LIFO (Last-In, First-Out) is not allowed in most countries primarily due to its potential distortion of financial statements. Last In First Out can lead to artificially lower profits and tax liabilities during inflationary periods, as it matches higher costs with revenue. This can create inconsistencies in financial reporting and may not accurately represent a company’s actual financial position.

Furthermore, Last In First Out can complicate international comparisons and hinder transparency. Therefore, many countries adopt other inventory valuation methods like FIFO (First-In, First-Out) or weighted average cost to maintain consistency, comparability, and fairness in financial reporting across businesses and industries.

The IFRS is not allowed to follow the LIFO valuation method but it is permitted in the US GAAP.

Advantages of the Last In First Out method

1. Tax advantages: LIFO can reduce tax liabilities during inflation by lowering taxable income.
2. Cash flow management: LIFO can help manage cash flow by reducing taxable income and deferring tax payments.
3. Reflects current costs: As LIFO matches recent inventory costs with current revenue, it provides a more accurate representation of the cost of goods sold.
4. Realistic valuation: The LIFO system aligns with the physical flow of inventory in many industries, where newer inventory is often sold first.
5. Cost recovery: LIFO allows businesses to recover costs quickly during inflationary periods.

Limitations of the LIFO method

1. Distorted inventory valuation: Due to the assumption that the most recent items are sold first, LIFO may not reflect the true value of inventory.
2. Complexity in record-keeping: In LIFO, inventory purchases and sales must be meticulously tracked, making accurate records more complex and time-consuming.
3. Noncompliance in some countries: LIFO is not allowed in many countries due to concerns about financial reporting consistency and comparability.
4. Reduced usefulness in deflationary periods: It can lead to distorted financial statements during deflation since LIFO assumes older, lower-priced inventory is sold first.

Also read : Just in time (JIT system)