Imagine running a business where your inventory costs are constantly rising. Would you rather report higher profits and pay more taxes, or prioritize cash flow and reduce your tax burden? The LIFO (Last-In, First-Out) method can be a strategic game-changer for businesses facing inflation. But how does it work, and is it the right fit for your business? This guide breaks down everything you need to know about LIFO — from how it works to its financial impact — so you can make informed decisions for your inventory management strategy.
What is the LIFO Method?
Understanding LIFO (Last-In, First-Out) in Inventory Management
The LIFO (Last-In, First-Out) method is an inventory valuation technique where the most recently acquired inventory items are sold or used first. This means that the newest inventory is accounted for before the older stock. LIFO is commonly used in industries where prices are rising, as it helps companies reduce taxable income by attributing higher costs to goods sold.
How LIFO Works: A Step-by-Step Explanation
Let’s break down how LIFO works with an example:
- A company purchases 100 units of a product at $10 each in January.
- In March, the company purchases 100 more units at $12 each.
- The company sells 150 units in April.
LIFO Calculation:
- 100 units at $12 (March purchase) = $1,200
- 50 units at $10 (January purchase) = $500
Total COGS = $1,700
Remaining Inventory:
- 50 units at $10 = $500
Visual Representation:
| Month | Units Bought | Unit Price | Units Sold | COGS | Remaining Inventory |
| January | 100 | $10 | 0 | $0 | 100 units @ $10 |
| March | 100 | $12 | 0 | $0 | 100 units @ $10, 100 units @ $12 |
| April | – | – | 150 | $1,700 | 50 units @ $10 |
LIFO vs. FIFO: Key Differences
LIFO vs. FIFO: A Comparative Analysis
| Aspect | LIFO | FIFO |
| Inventory Flow | Newest inventory sold first | Oldest inventory sold first |
| Financial Impact | Higher COGS, lower profit | Lower COGS, higher profit |
| Tax Benefit | Reduces taxable income | Higher taxable income |
| Acceptance | Not allowed under International Financial Reporting Standards (IFRS) | Accepted under Generally Accepted Accounting Principles (GAAP) and IFRS |
| Inventory Valuation | Can undervalue inventory | Reflects current market value |
LIFO vs. FIFO: Pros and Cons
LIFO: Pros and Cons
Pros:
- Reduces taxable income during inflationary periods
- Matches recent costs with current revenues
- Improves short-term cash flow
Cons:
- Not allowed under International Financial Reporting Standards (IFRS)
- Can undervalue inventory on the balance sheet
- May not align with the physical inventory flow
FIFO: Pros and Cons
Pros:
- Provides accurate inventory valuation
- Accepted under both Generally Accepted Accounting Principles (GAAP) and IFRS
- Often reflects actual product flow
Cons:
- Higher taxable income during inflation
- Can inflate profits artificially
LIFO in Action: Examples of LIFO Inventory Management
Real-World Example of LIFO in Use
A hardware store selling steel rods might use LIFO during periods of rising metal prices. The newest, more expensive stock is sold first, reducing reported profits and lowering taxable income. For example, if steel prices increased from $5 per rod to $7 per rod over three months, the hardware store would sell the $7 rods first. This method would report higher COGS and lower profits, resulting in a reduced tax liability.
LIFO Example in Different Industries
| Industry | How LIFO is Used | Benefit |
| Retail | Electronics inventory | Matches rising tech prices with current sales |
| Manufacturing | Raw materials like steel | Mitigates fluctuating material costs |
| Pharmaceuticals | High-value medications | Reduces tax liability with frequent price changes |
LIFO Inventory Valuation and Financial Impact
How LIFO Affects Financial Statements
During inflation, LIFO increases the Cost of Goods Sold (COGS) and reduces Net Income. This results in lower taxable income but can make the company appear less profitable to investors.
Example Chart:
| Method | COGS | Net Income | Taxes Paid |
| LIFO | $1,700 | $300 | Lower |
| FIFO | $1,500 | $500 | Higher |
LIFO and Tax Implications
LIFO provides tax savings during inflation but can lead to lower profits on financial statements. This could affect a company’s ability to attract investors or secure loans.
Other Inventory Valuation Methods
When to Use LIFO vs. Other Methods
| Method | Best For | Considerations |
| LIFO | Inflationary periods | Tax advantages, not IFRS-compliant |
| FIFO | Perishable goods | Higher taxable income |
| Weighted Average | Price fluctuations | Simpler to calculate |
| Specific Identification | Unique, high-value items | Accurate but time-consuming |
Benefits and Drawbacks of LIFO
Benefits of LIFO
- Tax savings in inflationary periods
- Matches recent costs with current sales
- Short-term cash flow advantages
Drawbacks of LIFO
- Not allowed under IFRS
- Distorts inventory value
- Less favorable for investor reporting
Last-In, First-Out (LIFO) FAQs
LIFO is an inventory valuation method where the most recently acquired items are assumed to be sold first. This approach matches current sales with the latest inventory costs.
While LIFO assumes the newest inventory is sold first, FIFO assumes the oldest inventory is sold first. This leads to different cost of goods sold and ending inventory valuations, especially during periods of price fluctuation.
Companies may choose LIFO during times of rising prices to match higher recent costs against revenues, potentially reducing taxable income.
LIFO is allowed under U.S. Generally Accepted Accounting Principles (GAAP) but is prohibited under International Financial Reporting Standards (IFRS).
Using LIFO can result in higher cost of goods sold and lower ending inventory values during periods of rising prices, which may lead to lower taxable income and net income.
LIFO can reduce taxable income in the short term during inflationary periods. However, if inventory levels decline, it can trigger higher taxable income due to the liquidation of older, lower-cost inventory layers.
Yes, but changing inventory valuation methods requires adherence to specific accounting guidelines and may have tax consequences. Companies should consult with accounting professionals before making such changes.
LIFO liquidation occurs when a company sells more inventory than it purchases, dipping into older inventory layers. This can result in recognizing older, lower costs as expenses, potentially increasing taxable income.
During inflation, LIFO assigns higher recent costs to Cost of Goods Sold (COGS), which can reduce taxable income. However, it also results in lower inventory valuations on the balance sheet.
Industries experiencing frequent price increases, such as the oil and gas sector, may find LIFO beneficial for tax purposes.
Conclusion
The LIFO method offers valuable tax benefits for businesses operating in inflationary environments. However, it comes with drawbacks such as restricted international acceptance and potentially misleading financial statements. Businesses should carefully assess their inventory needs and consult financial experts before adopting LIFO as their inventory valuation method.
About Qoblex
Since 2016, Qoblex has been the trusted online platform for small and medium-sized enterprises (SMEs), offering tailored solutions to simplify the operational challenges of growing businesses. Specifically designed for B2B wholesalers, distributors, and eCommerce ventures, our software empowers users to streamline operations from production to fulfillment, allowing them to concentrate on business growth. Qoblex efficiently manages inventory and order data across multiple sales channels including Shopify and WooCommerce, integrates with popular accounting systems such as Xero and QuickBooks, warehouses, and fulfillment systems, and boasts a robust B2B eCommerce platform. With a diverse global team, Qoblex serves a customer base in over 40 countries, making it a reliable partner for businesses worldwide.
