What is the LIFO Method?
The LIFO method (Last-In, First-Out) is an inventory valuation technique where the most recently purchased or produced goods are assumed to be sold first. This means that under LIFO, the cost of the latest inventory is matched with revenue, while older inventory remains in stock.
This method is less commonly used worldwide than FIFO but can have advantages in certain industries, especially when prices fluctuate or rise sharply.
Definition of Last-In First-Out (LIFO)
The last in first out principle means that the newest inventory items (last in) are sold or used first (first out). The older stock remains in the warehouse until newer items are cleared.
This approach is particularly useful when the cost of materials changes frequently and businesses want to align current expenses with current revenues.
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How the LIFO Method Works in Accounting
Under the lifo inventory valuation method , when calculating cost of goods sold (COGS), the latest inventory costs are used first. The remaining inventory on the balance sheet reflects older costs.
This often leads to higher COGS and lower profits during inflation, which can reduce taxable income.
Formula for Calculating LIFO Inventory and COGS
The formula for calculating COGS under LIFO is:
COGS = Cost of Most Recent Inventory Purchases × Quantity Sold
Ending Inventory = Value of older stock that remains unsold.
Example of the LIFO Method
Here’s a last in first out example:
100 units @ ₹50 each
100 units @ ₹60 each
If 120 units are sold, LIFO assumes the 100 units from the ₹60 batch and 20 units from the ₹50 batch are sold first.
COGS = (100 × ₹60) + (20 × ₹50) = ₹6,000 + ₹1,000 = ₹7,000
Ending Inventory = 80 units @ ₹50 = ₹4,000
This lifo method example shows that COGS is higher compared to FIFO, reducing profits during rising prices.
When Should Businesses Use the LIFO Method?
Businesses may use LIFO when:
- Prices are rising, and they want to match current costs with current revenues.
- They want to reduce taxable income during inflationary periods.
- Inventory turnover is high, and older stock does not lose value over time.
Where is the LIFO Method Commonly Applied?
The LIFO method is more commonly applied in the United States, as IFRS (used globally) does not allow LIFO. Under GAAP, however, companies can choose between LIFO, FIFO, and other methods.
Industries with volatile raw material prices—like petroleum, chemicals, and metals—are more likely to use LIFO.
Advantages of the LIFO Method
- Matches current costs with current revenues.
- Reduces taxable income during inflation, leading to tax savings.
- Can better reflect replacement costs of inventory .
Limitations of the LIFO Method
- Not accepted under IFRS, limiting global comparability.
- May understate inventory value on the balance sheet.
- Can distort profits if prices are falling.
- Older stock may remain unsold for long periods.
LIFO vs FIFO: Key Differences
Here’s a side-by-side comparison of the two most popular inventory valuation methods:
| Criteria | LIFO (Last-In, First-Out) | FIFO (First-In, First-Out) |
|---|---|---|
| Meaning | Latest inventory purchased is sold first | Oldest inventory purchased is sold first |
| COGS in Inflation | Higher (latest higher-cost stock sold first) | Lower (older cheaper-cost stock sold first) |
| Profitability | Lower (reduces taxable income) | Higher (increases taxable income) |
| Inventory Value | Older costs remain, undervaluing closing stock | Recent costs remain, closer to market value |
| Global Acceptance | Allowed under GAAP, not permitted under IFRS | Permitted under both IFRS and GAAP |
| Best For | Industries with volatile raw material prices | Businesses handling perishable or fast-moving goods |
| Tax Implication | Reduces tax liability in inflationary conditions | May increase tax liability in inflationary conditions |
| Financial Reporting | Shows conservative profits, less attractive to investors | Shows higher profits, may look better to investors |
Impact of Inflation on the LIFO Method
During inflation, LIFO increases COGS as the newer, more expensive stock is recorded as sold first. This reduces gross profit and taxable income. While this benefits companies from a tax perspective, it may make financial results look weaker compared to FIFO.
Conclusion
The lifo method is a strategic inventory valuation approach where the latest goods purchased are sold first. While it can offer tax advantages in times of inflation, it also has limitations, particularly regarding international reporting. Understanding the differences between LIFO and FIFO helps businesses choose the method that aligns with their goals and compliance requirements.
As a Chartered Accountant with over 12 years of experience, I am not only skilled in my profession but also passionate about writing. I specialize in producing insightful content on topics like GST, accounts payable, and income tax, confidently delivering valuable information that engages and informs my audience.
Frequently Asked Questions
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How is LIFO cost of goods sold calculated?
It is calculated by using the costs of the most recent inventory purchases first when recording sales.
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Is LIFO allowed under IFRS and GAAP?
LIFO is permitted under GAAP but not under IFRS, making it less common globally
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How does inflation affect the LIFO method?
Inflation increases COGS and lowers profits under LIFO, reducing taxable income but also reducing reported earnings.
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Which industries use the LIFO method the most?
Industries dealing with raw materials or commodities with volatile prices, such as oil, chemicals, and metals, commonly use LIFO.
