Definition
Last-In, First-Out (LIFO) is an inventory accounting method where the most recently purchased or produced items are recorded as sold first, meaning newer inventory costs are expensed before older inventory when calculating cost of goods sold. LIFO is permitted only in the United States under Generally Accepted Accounting Principles (GAAP) and is banned by International Financial Reporting Standards (IFRS) due to concerns about profit distortion.
Understanding LIFO
LIFO serves primarily as an accounting tool rather than a physical inventory management practice. When businesses use LIFO accounting, they expense the cost of their newest inventory purchases first, even though physically they may ship older products. This method becomes advantageous during inflation because higher recent costs reduce reported profits and consequently lower tax liability. Companies using LIFO typically operate in industries with non-perishable, high-cost inventory such as petroleum, metals, chemicals, and automotive dealerships.
The key distinction between LIFO accounting and actual inventory flow is important. Few businesses actually sell their newest inventory first physically—that would cause spoilage and obsolescence. Instead, LIFO is an accounting convention that affects financial reporting while physical operations often follow FIFO principles. The difference between inventory value under LIFO and FIFO is called the LIFO reserve, representing deferred tax liability.
Core Characteristics of LIFO
- Tax Advantages During Inflation: Higher COGS from recent expensive inventory reduces taxable income, providing tax benefits when prices rise
- US-Only Acceptance: Permitted under GAAP but prohibited by IFRS, limiting use to US domestic operations
- Contradicts Physical Flow: Typically doesn't match actual inventory movement, as most businesses sell oldest stock first
- Lower Reported Profits: Results in reduced gross income and net profit compared to FIFO during inflationary periods
- Outdated Balance Sheet Values: Ending inventory reflects older, potentially obsolete prices disconnected from current market values
LIFO in Practice
A consumer packaged goods company manufacturing canned soups provides a clear example of LIFO's impact. In January, the company purchases 500,000 pounds of steel for cans at $0.80 per pound. By November, with commodity prices rising, they purchase another 500,000 pounds at $0.95 per pound. When the company produces and sells products using 500,000 pounds that quarter, LIFO accounting expenses the higher recent costs first—$0.95 per pound—generating significantly higher COGS than FIFO would and reducing taxable income, saving approximately 21% of the difference in corporate taxes. However, the balance sheet shows ending inventory at the older $0.80 cost while current replacement cost is $0.95, creating a LIFO reserve that represents understated assets. Major CPG companies favor LIFO because ingredient and packaging costs tend to rise over time, and this becomes particularly significant during periods of rapid commodity inflation, where LIFO can reduce reported earnings by millions while preserving cash through tax savings.
Related Concepts
FIFO (First-In, First-Out) : The opposite inventory accounting method where oldest inventory costs are expensed first, resulting in higher profits during inflation and inventory values closer to current market prices.
Weighted Average Cost: An inventory valuation method that calculates a running average cost per unit, providing a middle ground between LIFO and FIFO without the extreme effects of either.
LIFO Reserve: The difference between inventory value under LIFO versus FIFO, disclosed in financial statements to allow analysts to compare LIFO companies with FIFO companies.
Inventory Layers: The distinct cost pools created under LIFO when inventory quantities increase, with each layer representing purchases from different periods at different costs.
LIFO Liquidation: When a company sells more inventory than it purchases, dipping into old LIFO layers with low historical costs, resulting in artificially inflated profits and higher taxes.
