When you run a business, it’s important to know how much you spend on inventory, so you can compare that to your revenue and calculate profit. But how do you keep track?
Well, tracing the cost of every single item you sell doesn’t work for most businesses. It’s too much work. That’s where inventory accounting methods, like the LIFO method, come in handy.
In this guide, we’ll focus specifically on the LIFO method. We’ll show you how to calculate it and how it compares to other options.
What Is the LIFO Method?
LIFO stands for Last In, First Out and is an inventory accounting method that assumes your newest inventory is sold first. In other words, the last ones in are the first to go!
You don’t actually have to sell your most recently purchased inventory items first to use the LIFO method. You just assume this when you do your accounting. There are many reasons why you’d do this, and we’ll get into those next.
Do note that the LIFO method is only used in the United States, which follows Generally Accepted Accounting Principles (GAAP).
The International Financial Reporting Standards (IFRS) used in countries like Canada and the U.K. do not permit the LIFO method since it can distort your company’s profitability. We’ll take a closer look at how that happens when comparing LIFO with other methods.
Why Use LIFO?
The LIFO accounting method works best for businesses that deal with rising inflation costs in their inventory, like grocery stores and pharmaceutical companies.
Why? Because the newer items you buy will be at a higher cost.
So if you’re calculating how much those goods cost…and how much they took out of your profits, you’ll want to use the most recent inventory to reflect those steep prices. Otherwise, your final profit calculation might be too high if it’s using the older, and cheaper, inventory as the baseline for costs.
Here's more information on the advantages, disadvantages, and regulations to ponder when considering LIFO for your accounting.
Advantages of Using LIFO
LIFO can be beneficial for tax purposes. Why? If you’re counting your inventory at the highest price, it’ll lower your profits. Lower profit means you have a lower taxable income. You pay fewer business taxes to the IRS with a smaller net income.
But this only happens if you’re in an inflationary business, which means your total cost of inventory always steadily increases.
Drawbacks of Using LIFO
On the other hand, if your inventory prices decline with time, the relationship switches. LIFO will overestimate profit and lead to higher income tax, while another method–First In, First Out or FIFO, will give you a lower net income calculation.
If your inventory costs remain steady or they could go up or down, use FIFO. It’s more widely accepted and used, and it gives the most accurate insights into the relationship between costs and profits.
Businesses that use LIFO and also report internationally need to prepare financial statements, such as the income statement and the balance sheet, using another method.
LIFO Inventory Method Sample Calculation
Let’s take a look at the LIFO inventory accounting method in action. Say you own a store that sells throw blankets, and for this accounting period, you sold 200 units at a sales price of $30, giving you a total revenue of $6,000.
Suppose your last two inventory orders were as follows:
Calculating COGS and Profit
First, you’ll calculate your cost of goods sold using the LIFO method.
Following LIFO, assume that the last 150 blankets you purchased were the first ones sold and the remaining 50 blankets came from your first batch of inventory.
COGS (using LIFO) = (150 x $8) + (50 x $6)
COGS (using LIFO) = $1,200 + $300 = $1,500
Based on the $1,500 cost of goods, your profit calculation would be:
Profit = Revenue – COGS
Profit = $6,000 – $1,500 = $4,500
Calculating Inventory Value
Finally, you can use LIFO to estimate the value of the remaining 70 blankets by using the cost of your oldest inventory. This calculation comes in handy when preparing financial statements, such as the balance sheet. The value of unsold inventory will be listed as a company asset.
Inventory Valuation (using LIFO) = 70 x $6
Inventory Valuation (using LIFO) = $420
LIFO vs. Other Costing Methods
When setting up your business accounting, LIFO is one option you can use for estimating costs and inventory values. Two other inventory valuation methods are FIFO and Average Cost.
Here’s how they compare to LIFO or Last In, First Out.
LIFO vs. FIFO
FIFO stands for the First In, First Out method, which is a cost flow assumption that says your oldest inventory gets sold first. In short, it makes the opposite assumption of LIFO.
If you used FIFO to calculate your costs, profit, and remaining inventory value from the previous example, it would look like this.
Your cost of goods sold calculation would use the unit price of the first batch of inventory to estimate the cost of the first 120 units sold, while the remaining 80 units would be expensed at the price of the second batch.
COGS (using FIFO) = (120 x $6) + (80 x $8)
COGS (using FIFO) = $720 + $640 = $1,360
So, FIFO gives you a lower cost calculation at $1,360 compared to the LIFO calculation of $1,500.
The lower cost estimate will then lead to a higher profit calculation.
Profit = Revenue – COGS
Profit = $6,000 – $1,360 = $4,640
The First In, First Out assumption gives a profit of $4,640, which is $140 higher than the calculation when using LIFO.
Finally, you’ll also see a difference in the book value of your ending inventory. Using the FIFO method, you assume that you sold the 120 units of the first batch, so the remaining inventory costs are valued at a unit price of $8.
Inventory Valuation (using FIFO) = 70 x $8
Inventory Valuation (using FIFO) = $560
Unsold inventory is valued at $140 more in FIFO than with LIFO—adding that much more to your assets column.
As you can see from these sample calculations, the method of inventory accounting you choose affects your cost of goods sold, profit, and inventory value. Unlike LIFO, the FIFO method is allowed under both GAAP and IFRS, so it can be used for reporting both in the U.S. and outside it.
The FIFO method is the most popular inventory valuation method since it offers more accurate insights into your actual cost of goods sold since most businesses do sell older inventory first.
LIFO vs. Average Cost
The third method we’ll consider is the average cost method, which uses a single cost estimate for all inventory. This type of inventory calculation works well for businesses that sell a large volume of similar products, such as phone cases.
Since all of their products have similar production costs, using an average makes it easier to handle the large volume of orders while still providing an accurate per unit cost estimate.
Instead of $6 for the first batch and $8 for the second, you would use an average unit price of $7 to calculate your costs. If you use the same information as before, the average cost accounting method gives you the following:
COGS (using Average Cost) = 200 x $7 = $1,400
Profit = $6,000 – $1,400 = $4,600
Inventory Valuation = 70 x $7 = $490
In this example, the prices of batches 1 and 2 were relatively close, so an average cost may be appropriate. But if you sell multiple products with very different production costs, the average cost method may not be the best.
For instance, if you spend $5 per unit on one product and $21 on another, you would get an average unit cost of $13, which doesn’t match either one well.
LIFO vs. Specific Inventory Tracing
Finally, we have the fourth method, which is specific inventory tracing, a.k.a. the specific identification method. With this technique, businesses trace the actual cost of goods sold for each unit of inventory sold, making it the most time-consuming one.
It can only be used by businesses that know the price of all the components in their product, for example, car dealerships. A car dealer may only have a few dozen units on their lot, and the production cost of each car can be found by adding the cost of add-on features to the base model cost.
Choosing an Inventory Management Method
As a business owner, you’ll need to understand inventory costs and how they relate to your profits. That way, you can figure out pricing and ordering–and ensure you still have enough money to pay all your expenses. If you deal with steady inflation related to inventory costs and only report in the U.S., LIFO may be the best accounting method for you. If not, FIFO is probably best.
No matter which bookkeeping method you choose, accounting standards say you have to be consistent. So if you use LIFO to calculate your expenses, you also need to use it to estimate the value of your remaining inventory and stick with it for each accounting period. Now that you know all there is to know about LIFO—all that’s left to do? Start tallying your orders!
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