Last In, First Out LIFO: The Inventory Cost Method Explained

The value of its remaining inventory is $2,100 (i.e., all the units added in Year 6). LIFO is based on the principle that the latest inventory purchased will be the first to be sold. Let’s examine how LIFO vs. first in, first out (FIFO) accounting impacts a hypothetical company, Firm A. This is why LIFO creates higher costs and lowers net income in times of inflation. Based on the LIFO method, the last inventory in is the first inventory sold. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100.

The practice of selling goods beyond the most recent purchase is called liquidation. As the corporation moves deeper into its LIFO layers, it begins to sell its earlier, lower-cost inventory stocks. As stated, one of the benefits of the LIFO reserve is to allow investors and analysts to compare companies that use different accounting methods, equally. The most important benefit is that it allows a comparison between LIFO and FIFO and the ability to understand any differences, including how taxes might be impacted. When a LIFO liquidation has occurred, Firm A looks far more profitable than it would under FIFO. This is because old inventory costs are matched with current revenue.

LIFO Liquidation is typically not seen as a sustainable strategy, as it may result in liquidating older, lower-cost inventory, leaving more expensive inventory in stock. This could eventually lead to higher taxes and lower profits when the cheaper inventory is exhausted. LIFO Liquidation reduces the cost of goods sold and increases the gross margin and net income. This is because the older and cheaper units of inventory are sold off, lowering the overall cost of goods sold. The implications may include a sudden increase in net income due to lower cost of goods sold, taxable income, and the potential distortion of the firm’s financial picture if not properly managed.

  1. Access and download collection of free Templates to help power your productivity and performance.
  2. When they begin selling inventory beyond that most recent purchase, the process is known as liquidation.
  3. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax.
  4. LIFO liquidation refers to the practice of discount selling older merchandise in stock or materials in a company’s inventory.

However, it’s a one-off situation and unsustainable because the seemingly high profit cannot be repeated. Therefore, its gross profit from selling out its inventory would be $1,975, or $6,000 in revenue – $4,025 in COGS. This scenario occurs in the 2010 financial statements of ExxonMobil (XOM), which reported $13 billion in inventory based on a LIFO assumption. In the notes to its statements, Exxon disclosed the actual cost to replace its inventory exceeded its LIFO value by $21.3 billion. As you can imagine, under-reporting an asset’s value by $21.3 billion can raise serious questions about LIFO’s validity. Under FIFO, Firm A doesn’t touch any of the inventory it added in Year 6.

Which Is Better, LIFO or FIFO?

Some companies may provide discounts on the old stock to increase sales. During economic downturns, LIFO liquidation could result in higher gross profit than would otherwise be realized. If the LIFO layers of inventory are temporarily depleted and not replaced by the fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits. Many companies frequently change their sales mix as they grow their business. This approach may prove costly as well as time consuming for such companies because they have to redefine the inventory pools each time a change in mix of their products occurs. The other thing that happens with LIFO is the inventory value as reflected on the balance sheet becomes outdated.

what is technical review in software testing is a strategy employed by businesses during periods of rising prices or inflation to reduce their taxes and consequently increase their profitability. The LIFO (Last In, First Out) method of inventory accounting corresponds to the assumption that the last items to enter a company’s inventory are the first ones to be sold. Thus, when a LIFO liquidation occurs, it means that a firm is selling off older inventory that was acquired at lower costs. This practice has the effect of increasing a company’s tax liability because higher gross profits mean higher taxable income.

Why LIFO Is Banned Under IFRS

The company usually keeps some inventory in warehouse in order to prevent any shortage, and these inventories are known as inventory minimum level. The purchasing department will place the order when the inventory level is approaching this level. It is the inventory level that company place order and receive material without disturbing the production process. It also helps to minimize the storage cost which incurs when company stores inventory more than it needs. LIFO liquidation may also generate positive cash flow and result in higher taxable income and higher tax payments. Some of the experts and managerial gurus suggest LIFO Inventory Pool prevents the impact of LIFO Liquidation on the net income.

Related Finance Terms

The process provides a lower cost of goods sold (COGS), which increases gross profits, and generates more income to be taxed. ABC Company uses the LIFO method of inventory accounting for its domestic stores. It purchased 1 million units of a product annually for three years. The per-unit cost is $10 in year one, $12 in year two, and $14 in year three, and ABC sells each unit for $50. It sold 500,000 units of the product in each of the first three years, leaving a total of 1.5 million units on hand. Assuming that demand will remain constant, it only purchases 500,000 units in year four at $15 per unit.

The company wants to get rid of the old inventory before it becomes obsolete or even written off. As we know the inventory will face a high risk of obsolete when they are kept in the warehouse for longer than usual time. When they stay for a certain period of time, they are highly likely to stay forever. The customers will be looking to purchase the new fresh stock even if the quality is similar. To solve this problem, the warehouse manager arranges the old stock and tries to sell them before they are too old.

For example, imagine that Firm A buys 1,500 units of inventory in Year 6 at a cost of $1.40. If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement. In tough financial times, LIFO Liquidation may boost profits on paper, allowing a firm to appear healthier. However, it could also indicate a company’s struggle to purchase or produce new inventory, signaling potential financial distress.

Therefore, it will provide lower-quality information on the balance sheet compared to other inventory valuation methods as the cost of the older snowmobile is an outdated cost compared to current snowmobile costs. The cost of inventory may be decreased due to the market condition, which also impacts our financial statements. The cost of goods will decrease immediately, which will increase the profit, while the inventory in the balance sheet may decrease or even stay the same base on the sale volume. B is incorrect because if inventory unit costs rise and LIFO liquidation occurs, an inventory-related increase, and not decrease, in gross profits will occur. At the end of the day, companies are reluctant to match the lower cost of goods from their old inventory with the current higher sales prices. When put head to head, it artificially generates higher gross margins and profits, attracting more income tax.

Total gross profit would be $2,675, or $7,000 in revenue – $4,325 cost of goods sold. That’s 1,000 units from Year 1 ($1,000), plus 500 units from Year 2 ($575). In terms of accounting, the older stockpiles in the company’s inventory are often called layers. Since the company buys new inventory in every financial period, the old inventory stacks up. This happens most commonly in businesses that use the LIFO method.

Access and download collection of free Templates to help power your productivity and performance. Specific goods pooled LIFO approach is not a perfect solution of LIFO liquidation but can eliminate the disadvantages of traditional LIFO inventory system to some extent. Assume that the Delta company needs to use 18,000 meters of copper coil during the year 2023 but the company experiences a shortage of it and, therefore, must liquidate much of its old copper coil inventory.

But, it has an impactful consequence on the financial statements indeed. You might have seen something while going through any company’s financial statements. The LIFO method is used by most companies when there is higher inflation. As a result, the company tries to match the cost of goods sold with the market prices.