The last in, first out, or LIFO (pronounced LIE-foe), accounting method assumes that sellable assets, such as inventory, raw materials, or components, acquired most recently were sold first. The last to be bought is assumed to be the first to be sold using this accounting method. (In contrast, FIFO – first in first out – assumes the oldest inventory is the first to sell.)
Of course, the assumption is that prices are steadily rising, so the most recently-purchased inventory will also be the highest cost. That means that higher costs will yield lower profits, and, therefore, lower taxable income. And that is the only reason a company would opt to use the LIFO method.
However, because it keeps profits artificially lower, LIFO is only used in the U.S. – it’s prohibited in other countries.
LIFO in practice
Let’s pretend that your store purchased three shipments of stock in the last three months. The summary looks like this:Month Cost of Inventory Retail Price Janurary $1000 $4000 February $2000 $4000 March $3000 $4000
Using LIFO, when that first shipment worth $4,000 sold, it is assumed to be the merchandise from March, which cost $3,000, leaving you with $1,000 profit. The next shipment to sell would be the February lot under LIFO, leaving you with $2,000 profit.
Why LIFO isn’t used to manage inventory
While LIFO is used to account for inventory values, in truth, it would be impractical in the real world. It’s not practical.
Using LIFO to arrange inventory would ensure that the oldest inventory would become obsolete and unsellable, being constantly pushed in the back of the store to make room for the newer items up front. If the only inventory that was sold was the newer items, eventually the older stock would be worthless. That’s not a good way to run a business.
When LIFO causes issues
Besides minimizing tax obligations, LIFO can also wreak havoc on inventory valuations when an industry is experiencing strong inflation or declining values. For example, if the replacement cost of a business's inventory exceeds its LIFO value, a business risks undervaluing its inventory when filing small business taxes.