Last In First Out, also known as the LIFO inventory method, is one of five different ways to value inventory. LIFO assumes that the most recent items purchased (the newest items) are sold first. LIFO is best for businesses that sell non-perishable products that do not require refrigeration and generally have a longer shelf life.
In this article, we will discuss how to calculate the value of inventory using LIFO, the cost of goods sold under this method and advantages and disadvantages of using the LIFO inventory method.
How Does the LIFO Inventory Method Work?
The LIFO inventory method assumes that the most recent purchases are sold first. For example, let’s say you own an office supply store and you receive an order of 200 notebooks every week. Most likely, when you receive a shipment, you will put them on the shelf in front of the existing products.
When calculating the cost of goods sold in your books, you will assume the newest shipment is purchased first, until 200 units sell out. This is in contrast to First in First out (FIFO), which assumes the oldest products are sold first. The difference may seem nuanced, but it becomes very important when prices fluctuate from the supplier; due to inflation or market conditions.
For example, if the first shipment cost you $1.00 per unit, and the second cost you $1.25, the two inventory methods would lead to different values for the cost of goods sold, and thus, different net profits, tax liabilities, and so on.
What Type of Business Is LIFO Best For?
If you fit the description above— a business that sells nonperishable items, and stocks the newest items first— then LIFO will give you the most accurate calculation of your inventory value and sales profit. This includes retail businesses that sell clothing, shoes, office supplies and tools.
That said, even businesses that don’t fit this description will sometimes use LIFO for its potential tax advantages. Under the LIFO method, your cost of goods sold is generally higher (assuming inflation has increased prices throughout the year), which means a lower net profit, and thus, a lower income tax liability.
On the flipside, businesses may be hesitant to present themselves as having a lower profit and inventory value. Under LIFO, the inventory that remains on the shelf at the end of the year will be valued at a lower cost (assuming inflation), which yields a weaker balance sheet report. When presenting to potential investors or lenders, some businesses may opt to use the FIFO inventory method instead — although in this case, the IRS requires a footnote showing the inventory value under LIFO as well.
What are the Advantages/Disadvantages of using the LIFO Method?
Some advantages of using LIFO inventory method are:
- LIFO results in a higher cost of goods sold number. This is due to the fact that newer items generally tend to carry a higher cost than older items purchased, due to potential price increases.
- A higher cost of goods sold number will result in a lower profit. While this might not sound like a good thing, remember that the higher your profit the more you could pay in taxes.
- It’s easier to manage inventory stock. Because there are no expiration dates to worry about or products that could potentially spoil, your employees can just put items on the shelf without having to keep track of what was purchased first (or last).
- A lower tax bill. As I mentioned previously, LIFO results in a higher cost of goods sold which will yield a lower profit and a lower tax bill.
Here are a couple of disadvantages of using LIFO Inventory Method:
- A lower profit. As discussed, a higher cost of goods sold will result in a lower profit margin and a lower tax bill. If you are trying to qualify for a line of credit or a business loan, showing a lower profit margin may not work in your favor.
- Accounting software like QuickBooks Online or Xero do not use the LIFO method to track inventory; however, you can purchase an inventory app that does offer LIFO inventory valuation and integrates with QBO or Xero. Check out the QuickBooks App store or the Xero Marketplace to see what your options are.
How Do I Calculate Inventory Value Using the LIFO Method?
Let’s go back to our office supply store example and assume that we have the following inventory on-hand for staplers, pen, and notebooks:
Our current inventory value is in the last column. It is calculated by multiplying the cost of each item by the quantity onhand.
Now let’s assume that we have made the following purchases:
To calculate our new inventory quantity & value, we need to take the current inventory and add our purchases as follows:
Quantity: 10 + 10 = 20 staplers
Value: $50 + $60 = $110
Quantity: 10 + 20 = 30 pens
Value: $5 + $20 = $25
Quantity: 10 + 15 = 25 notebooks
Value: $10 + $30 = $40
Total Inventory Value for all 3 of our products is $175. Since inventory is an asset, this amount would appear on the balance sheet report, in the assets section.
How Do I Calculate Cost of Goods Sold Using the LIFO Method?
Continuing with our office supply example, let’s assume that we have sold the following items:
The cost of goods sold would be calculated as follows for each item:
Sold 15 Staplers:
10 @ $6.00 = $60.00
5 @ $5.00 = $25.00
Cost of Goods Sold = $85.00
Under the LIFO method, you pull 10 of the staplers from the most recent purchase of staplers that cost $6.00 each and the remaining 5 staplers from the original inventory that was purchased at $5.00 each.
Sold 20 Pens:
20 @ $1.00 = $20.00
Cost of Goods Sold = $20.00
Under the LIFO method, you pull all 20 pens from the most recent purchase of pens that cost $1.00 each.
Sold 20 Notebooks:
20 @ $2.00 = $40.00
Cost of Goods Sold = $40.00
Under the LIFO method, you pull all 15 notebooks from the most recent purchase of notebooks that cost $2.00 each and the remaining 5 notebooks come from the original inventory that was purchased at $1.00 each.
The total cost of goods sold for these items is $145 ($85+$20+$40). This amount would appear on the Profit & Loss statement as a reduction of gross profit.
The Bottom Line
Now that you have a better understanding of how the LIFO inventory method works, I strongly recommend that you invest in an inventory management system that will help you maximize your profits without taking up valuable time. If you’re unsure which inventory method you should use, read additional information on inventory accounting methods and make the decision that is best for your small business.