Last In, First Out (LIFO)

What is LIFO?

Last In, First Out (LIFO) is an inventory-costing method that assumes the most recently purchased or produced items are sold first. Under LIFO, the cost of the newest inventory is recorded as cost of goods sold (COGS), while older, often lower-cost items remain on the balance sheet as ending inventory.

Common alternatives:
* First In, First Out (FIFO) — oldest items are sold first.
* Average cost method — uses a weighted average cost for all units.

Key takeaways

• LIFO matches current (recent) costs against current revenues, which raises COGS when prices are increasing.
• In periods of inflation, higher COGS under LIFO generally lowers reported net income and taxable income, improving short-term cash flow.
• LIFO is permitted under U.S. GAAP but is not allowed under International Financial Reporting Standards (IFRS), so it is primarily used by U.S. companies.
• FIFO typically produces higher reported net income and a more representative ending inventory value during inflation.
• The average cost method yields results between FIFO and LIFO.

How LIFO works and who uses it

Under LIFO, when inventory is sold, the cost assigned to COGS is taken from the most recent purchases. This approach is common among businesses that maintain large, frequently replenished inventories (e.g., some retailers, wholesalers, auto dealerships) because it can reduce taxable income during inflationary periods.

Tax and reporting considerations:
* In the U.S., tax rules generally require consistency (conformity) between tax filings and financial reporting—if a company elects LIFO for tax purposes, it typically must use LIFO in its financial statements as well.
* Public companies often prefer FIFO because higher reported earnings can be more attractive to shareholders.

Impact of inflation and deflation

• Inflation: LIFO produces higher COGS and lower ending inventory values, resulting in lower net income and lower taxes compared with FIFO. It may also reduce the frequency of inventory write-downs because older, lower-cost layers remain on the books.
• Deflation: The effects reverse—LIFO leads to lower COGS, higher net income, and potentially higher taxes.

Example

A company receives 10 widgets: 5 at $100 each, then 5 at $200 each. Seven widgets are sold at the same sales price.

• LIFO COGS: the five $200 units are sold first (5 × $200 = $1,000) plus two of the $100 units (2 × $100 = $200) → total COGS = $1,200.
• FIFO COGS: the five $100 units are sold first (5 × $100 = $500) plus two of the $200 units (2 × $200 = $400) → total COGS = $900.

Because revenue is the same either way, higher COGS under LIFO reduces gross profit and pre-tax income compared with FIFO, lowering taxable income during inflation.

Advantages and disadvantages

Advantages
* Reduces taxable income during inflation, improving cash flow.
* Matches current costs with current revenues, which can be informative for cost-of-sales analysis.

Disadvantages
* Ending inventory may be understated and not representative of current replacement cost.
* Can make financial comparisons across companies or periods more difficult.
* Not permitted under IFRS, limiting international comparability.
* Using LIFO for tax purposes generally requires using it for financial reporting (conformity rule), which lowers reported earnings.

When to use LIFO

LIFO can be advantageous for businesses that:
* Maintain large, continuously replenished inventories.
* Operate in inflationary environments and prioritize tax deferral and cash flow.
* Are U.S.-based and able to apply LIFO consistently for tax and financial reporting.

When not to use LIFO

• If accurate, up-to-date inventory valuation on the balance sheet is a priority.
• If a company reports under IFRS or needs international comparability.
• If management prefers higher reported earnings to satisfy investors.

Summary

LIFO is an inventory-costing method that assigns the cost of the most recent purchases to COGS. It reduces taxable income and reported profits during inflation but can understate ending inventory values. Because IFRS prohibits LIFO, it remains primarily a U.S. accounting practice. Choice of inventory method should reflect a company’s tax strategy, reporting requirements, and the need for meaningful inventory valuation.