The LIFO inventory method assumes that the cost of the latest units purchased are

What is Last In, First Out (LIFO)?

The last in, first out method is used to place an accounting value on inventory. The LIFO method operates under the assumption that the last item of inventory purchased is the first one sold. Picture a store shelf where a clerk adds items from the front, and customers also take their selections from the front; the remaining items of inventory that are located further from the front of the shelf are rarely picked, and so remain on the shelf – that is a LIFO scenario.

The trouble with the LIFO scenario is that it is rarely encountered in practice. If a company were to use the process flow embodied by LIFO, a significant part of its inventory would be very old, and likely obsolete. Nonetheless, a company does not actually have to experience the LIFO process flow in order to use the method to calculate its inventory valuation.

Effects of LIFO Inventory Accounting

The reason why companies use LIFO is the assumption that the cost of inventory increases over time, which is a reasonable assumption in times of inflating prices. If you were to use LIFO in such a situation, the cost of the most recently acquired inventory will always be higher than the cost of earlier purchases, so the ending inventory balance will be valued at earlier costs, while the most recent costs appear in the cost of goods sold. By shifting high-cost inventory into the cost of goods sold, a company can reduce its reported level of profitability, and thereby defer its recognition of income taxes. Since income tax deferral is the only justification for LIFO in most situations, it is banned under international financial reporting standards (though it is still allowed in the United States under the approval of the Internal Revenue Service).

Alternative Costing Methods

A more realistic cost flow assumption is incorporated into the first in, first out (FIFO) method. This approach assumes that the oldest inventory items are used first, so that only the newest inventory items remain in stock. Another option is the weighted average method, which calculates the average cost for all items currently in stock.

Example of the Last-in, First-out Method

Milagro Corporation decides to use the LIFO method for the month of March. The following table shows the various purchasing transactions for the company’s Elite Roasters product. The quantity purchased on March 1 actually reflects the inventory beginning balance.

The following bullet points describe the transactions noted in the preceding table:

• March 1. Milagro has a beginning inventory balance of 150 units, and sells 95 of these units between March 1 and March 7. This leaves one inventory layer of 55 units at a cost of $210 each.

• March 7. Milagro buys 100 additional units on March 7, and sells 110 units between March 7 and March 11. Under LIFO, we assume that the latest purchase was sold first, so there is still just one inventory layer, which has now been reduced to 45 units.

• March 11. Milagro buys 200 additional units on March 11, and sells 180 units between March 11 and March 17, which creates a new inventory layer that is comprised of 20 units at a cost of $250. This new layer appears in the table in the “Cost of Layer #2” column.

• March 17. Milagro buys 125 additional units on March 17, and sells 125 units between March 17 and March 25, so there is no change in the inventory layers.

• March 25. Milagro buys 80 additional units on March 25, and sells 120 units between March 25 and the end of the month. Sales exceed purchases during this period, so the second inventory layer is eliminated, as well as part of the first layer. The result is an ending inventory balance of $5,250, which is derived from 25 units of ending inventory, multiplied by the $210 cost in the first layer that existed at the beginning of the month.

The last-in, first-out (LIFO) method is one of the three inventory cost flow assumptions, alongside the FIFO (first-in, first-out) and average cost methods. The LIFO method is popular in the United States because it’s allowed for tax purposes, and proponents argue that it’s an appropriate method of costing inventory because it most closely matches the replacement cost of inventory.

Let’s explore the LIFO method and discover if this is the best fit for your inventory needs. You can learn about other methods of tracking inventory costs in our guide to cost of goods sold (COGS).

How the LIFO Inventory Method Works

As indicated by the name itself, the LIFO method bases the COGS on the cost of the most recent purchases (last in). It means that recently purchased goods are expected to be expensed first or transferred to the COGS.

Cost flow illustration of the LIFO inventory method

The diagram above shows how the LIFO method works. The four paddles present at the beginning of the period at $38 each are still included in inventory at the end of the period. This is because the most recent paddles purchased were assigned to Cost of Goods Sold under the LIFO inventory method.

LIFO is an assumption about cost flow that doesn’t have to match the actual physical flow of goods. In the illustration above, it’s OK if the four physical paddles in beginning inventory were sold during the year. A company can still assign costs to ending inventory assuming the four paddles are still physically in the inventory.

Hence, the cost of ending inventory is $192, composed of four units in beginning inventory (4 units x $38 each) and one unit from purchases (1 x $40 each).

What Type of Business LIFO Is Best For

• Businesses that elect the LIFO method in the tax returns: The IRS requires businesses who elect the LIFO for tax purposes to apply the same method in their book accounting.
• Merchandise businesses that want to reduce income tax obligations: The generally accepted accounting principles (GAAP) allow businesses to use the LIFO method for inventory costing. The major advantage of the LIFO method is its ability to reduce your taxable income because it reports higher COGS when prices are increasing. Choosing LIFO for tax and accounting is one way to reduce your tax obligations.
• Businesses looking to manipulate net income: LIFO results in unit costs being included in ending inventory that go back many years or even decades. A company using LIFO can report a low COGS or high net income in a year by reducing their level of inventory to have some of these low costs from prior years included in current-year COGS. This technique is referred to as a LIFO liquidation.

What Type of Business LIFO Is Not Right For

• Businesses with low-volume, high-value items: The LIFO method isn’t recommended if you don’t keep track of inventory by bulk. Companies that sell luxurious and expensive items, such as jewelry, equipment, or vehicles, don’t often store large volumes. The specific identification method is more suitable in this case.
• Businesses selling highly perishable goods: Fruits and vegetables don’t have long shelf lives, and it’s common sense to use the FIFO physical flow to prevent spoilage. While it’s acceptable to still use LIFO, FIFO will do a better job of matching actual costs.
• Manufacturing businesses: In a manufacturing setup, companies set up three types of inventory: raw materials, work in process, and finished goods. If the LIFO method is used, LIFO layers must be tracked separately for each type of inventory and can become very complicated.
• Businesses looking for an easy inventory accounting method: LIFO is difficult to use both in the periodic and perpetual inventory systems. Inventory costs can layer up and make recordkeeping tedious.
• Periodic inventory systems: Businesses that use a periodic inventory system likely do so because of its simplicity. To keep this simple, these businesses should use FIFO instead of LIFO. With FIFO, the costs in ending inventory can be determined easily by looking at the last inventory purchases of the period.

Advantages & Disadvantages of Using the LIFO Method

How To Calculate Ending Inventory and COGS Using the LIFO Method

Periodic Inventory System Using LIFO

Being systematic is the key to understanding how the LIFO method works. You have to keep track of inventory numbers in every transaction. However, the way of computation may differ if you’re using the periodic inventory vs perpetual inventory system. Let’s see how they work.

In a periodic inventory system, you only update the inventory account at the end of the period, such as monthly, semiannually, or annually, after a physical inventory count. To arrive at COGS, we first determine the cost of ending inventory.

Let’s compute the ending inventory step by step using the sample data taken from the inventory records of a company selling table tennis paddles.

Step 1: Count the Number of Units in Ending Inventory Physically

The periodic inventory system requires a physical count of inventory at the end of the period. Most companies using periodic inventory systems are small businesses that only count inventory and calculate COGS once per year. However, if you want to use the periodic inventory system monthly, you can estimate the units in ending inventory without taking a physical count.

Assume our physical inventory count reveals 80 units in ending inventory.

Step 2: Calculate the Cost of Ending Inventory Based on the Oldest Prices

Under the last-in, first-out assumption, we always remove goods sold from the most recent purchase. This means that the goods sitting in the ending inventory are the earliest purchases. From Step 1, we know that there are 80 units in ending inventory. By looking at the purchases schedule in Step 2, we can assign costs to the 80 units by applying the oldest purchase price first.

We have 80 units to account for in our ending inventory. Our beginning inventory of 30 units–the first LIFO layer–is not enough to cover for the 80 units. Hence, we get 50 more units from the second LIFO layer, the January 5 purchase. Therefore, the cost of ending inventory would be computed this way:

The company has two groups of inventory – one at $35 per unit and another at $36 per unit. These groups are referred to as LIFO layers.

Step 3: Compute the COGS

Now that we know the cost of ending inventory, we can use the COGS formula to calculate our COGS.

Perpetual Inventory System Using LIFO

Under the perpetual inventory system, we determine the COGS and inventory after every sale instead of waiting until the end of the year. This requires much more work and is only recommended if you use inventory management software that can integrate with your accounting software. inFlow is an inventory management software that can use LIFO and integrate with popular accounting software like QuickBooks Online and Xero. However, we’ve developed a spreadsheet to help you track LIFO layers if you don’t have the appropriate software.

Below you’ll find the sample format of our LIFO records. We recommend you set up a similar sheet in Excel or Google Sheets.

LIFO layers stay in your records for months, if not years. You’ll want to save your spreadsheet as a permanent file to carry from year-to-year versus starting a new spreadsheet each year.

The process for perpetual LIFO is similar to periodic LIFO, except that you must apply the LIFO rules for each sale throughout the year, instead of waiting until the end. Perform the following steps for each sale during the year:

Step 1: Examine Your LIFO Layers Prior to the Sale

As of January 5, we have two LIFO layers. Preparing a schedule of LIFO layers before updating perpetual records for a sale is important in making sure you take COGS from the most recent layer. Take note that you have to repeat this step before you make entries to LIFO layers. This schedule will serve as your guide to what layer needs to be updated.

Step 2: Remove Units Sold From Most Recent Layers and Transfer Cost to COGS

Let’s repeat Step 2 to account for the sale that occured on January 15. There’s no need to update the schedule for any additional purchases, because there were none between the sales on 1/10 and 1/15.The sale on January 10 was deducted from the January 5 purchase, the second and most recent layer. We will only use the units in beginning inventory if the most recent purchases aren’t enough to cover the sale.

After the January 10 sale, we still have 150 units from the second layer and it is enough to cover the January 15 sale of 120 units. Hence, we still deduct the sale from the second layer. Afterward, let’s extend and foot the totals in the last two columns. As of January 15, we still have 30 units from beginning inventory and 30 units from the January 5 purchase. Our COGS as of this date is $9,720.

Let’s account for the sale on 1/25 by first updating the LIFO spreadsheet (step 1) for the 1/20 purchase:

We can use the schedule above as a guide when updating perpetual records for the 1/25 sale:

In our last transaction above, we withdraw inventory costs from three different layers. On January 25, we sold 250 units. First, we get to subtract all 200 units from January 20. We still have 50 remaining units so we go up to the next LIFO layer. The remaining layer from January 5 is only 30 units so we get all of the 30 units and proceed to the last LIFO layer for the remaining 20 units.

Since our last LIFO layer has 30 units available, we get 20 units from that layer and leave the remaining 10 units as ending inventory. The total COGS under LIFO for our January 25 sales is summarized below:

Difference Between Periodic and Perpetual Inventory Systems Using LIFO

Your cost of ending inventory and COGS for the period comes from the schedule with no further adjustments. Notice the cost of inventory and COGS are different under the perpetual and periodic inventory systems since the goods sold come from different LIFO layers.

Overall, the perpetual inventory system using LIFO can be tedious. Even if you’re using a spreadsheet, adding new layers and modifying existing layers takes a lot of data entry and cleaning up. This is the reason why some prefer the periodic inventory system because of its simplicity.

Bottom Line

The last-in, first-out method is an inventory cost flow assumption allowed in by US GAAP and income tax laws. The LIFO method proponents argue that the LIFO method improves the matching of revenues and replacement costs. However, the cost of ending inventory presented in the balance sheet presents older costs. More importantly, users of the LIFO method say that using LIFO gives them tax savings since they report a lower taxable income.

What does the LIFO method assume?

Does LIFO report the latest costs for ending inventory?

Does LIFO lower cost of goods sold?

Does LIFO yield lowest gross profit?