Below, we’ll explore what the LIFO method is, how it works, and when it’s the best option for certain companies.
The LIFO method is a common way of valuing a company’s inventory. It’s an accounting term that stands for “Last In, First Out”, with the understanding that the newest shipments of goods are the ones the company sells to customers first.
Thus, the items that remain unsold in inventory are the ones that were purchased the earliest. The price of these goods will determine the total value of inventory. On the other hand, the value of items sold becomes your cost of goods sold (COGS). This is a line item on the income statement, which gets subtracted from total revenue to determine the gross profit for the period.
Under the LIFO method, companies ensure customers are sold the newest goods from the latest shipments, giving them a competitive advantage when peers are still selling older inventory.
Keep in mind, LIFO is just one of the three methods companies can use to value their inventory. The other two methods include average cost inventory or “First In, First Out” (FIFO).
Each of the three inventory valuation methods we listed above is acceptable under generally accepted accounting principles (GAAP) in the United States. So, when is it best to use the LIFO method?
The general outcome of using the LIFO method is a lower inventory value on the balance sheet and a higher COGS on the income statement. This is based on the assumption that prices for goods steadily increase over time. So, the inventory you purchased previously will cost less than the same units of inventory purchased today.
If you’re selling the most recent shipments to customers before dipping into your older inventory, you will incur higher COGS, while the value of remaining inventory is lower given the cheaper purchase price pre-inflation.
Thus, the LIFO method can be a better option for companies with larger volumes of inventory. It allows them to benefit from a lower tax liability by decreasing their profits with a higher cost of goods sold.
Regardless of the method you select, in order to remain compliant with GAAP, you’ll need to remain consistent with the method to ensure accurate and transparent financial reporting.
After learning the basics of the LIFO method for valuing inventory, let's explore this method in further detail with an example of how it looks in a real-world setting.
A growing clothing retailer purchases inventory throughout the year. The company uses the LIFO method for inventory to prioritize a lower tax liability and keep a light balance sheet.
To prepare for the back-to-school season and keep up with summer shopping demands, the company makes one large purchase during the second quarter. They have some older shipments still in stock. But, because they use the LIFO method, they will fulfill customer orders using the newest inventory first.
Here is a breakdown of the current items that the retailer has in stock before its latest round of purchases:
Then, the company receives a new shipment:
Throughout the quarter, the company sells 200 shirts. Under the LIFO method, this means they sell the newer-received stock first. So, after considering the current period sales, there are still 50 shirts from the new shipment in stock. This is valued at:
50 * $14 = $700
Then, we need to add this value to the value of the older shipment of shirts that are still in stock. As we previously calculated, this inventory is valued at $1,680.
We combine these two values to determine the total value of ending inventory under the LIFO method:
$700 + $1,680 = $2,380
To sum it up, the company will report an inventory of $2,380 on the balance sheet, and this value will be used to calculate the company’s COGS for the income statement.
Each method of valuing inventory has advantages and drawbacks. It’s important to consider the potential impact of an inventory method on your company’s accounting and financial statements before selecting one.
To help you better understand if LIFO is the best option for your business, we’ll now walk through some of the pros and cons of this method.
The LIFO method is a common choice for valuing inventory. The method provides favorable tax advantages, though it will result in a lower profit on the income statement. The LIFO method isn’t for everyone, and it’s not permitted in all countries, though it can produce a number of benefits in the right circumstances.
Each company needs to thoroughly assess each option before choosing LIFO, FIFO, or the average cost method. Companies have the power to choose between either three. However, they must be consistent with a method once it’s chosen to remain compliant with US accounting standards.
If you want expert guidance on which method to select and how to implement it, contact us at Bob’s Bookkeepers to speak with one of our experienced advisors today.
