7.4: LIFO: Last-in, First-out

Creating a strategy for valuing inventory is not just an accounting choice, as it can directly affect how a company reports profits, manages taxes, and evaluates performance. One such method, LIFO (Last-in, First-out), is especially relevant in industries where prices, such as energy or raw materials, tend to rise quickly.

How LIFO Works in Rising Price Environments
LIFO assumes that the most recent inventory purchases are the first to be sold. As a result, the cost of goods sold (COGS) reflects the latest, often higher, acquisition costs. This leads to a lower gross profit when prices are rising, since expenses appear higher. For example, if a company acquires fuel in three successive batches at increasing prices and then sells part of its stock, LIFO will first assign the sale to the newest (most expensive) inventory.

During inflation, LIFO records the latest, higher-priced inventory as sold first. This raises the cost of goods sold (COGS) and reduces reported net income. Companies in industries with frequent price swings often choose LIFO because it matches today’s revenues with today’s costs, giving a more accurate picture of current profit margins.

This has two significant implications. First, it reduces reported net income, since higher COGS means lower taxable profits. Second, it produces a lower ending inventory value on the balance sheet because older, cheaper goods remain recorded in stock. These outcomes can benefit cash flow management and tax deferral in the short term.

Comparative Implications and Limitations
Unlike FIFO (First-in, First-out), which reports higher profits during inflationary periods, LIFO matches current revenues with current costs more realistically. However, this can also distort inventory values on the balance sheet, making assets appear undervalued.

It's also important to note that LIFO is not permitted under International Financial Reporting Standards (IFRS), limiting its use to jurisdictions like the United States under Generally Accepted Accounting Principles (GAAP). This regulatory distinction affects multinational firms, which may need to reconcile differing inventory valuation practices across regions.

LIFO, or Last-in, First-out, is an inventory valuation method that assumes that the most recently acquired items are sold first. It is an accounting convention and does not reflect the actual order in which inventory is sold.

This method is frequently applied to homogeneous, non-perishable products in sectors experiencing regular price changes, such as the crude oil industry.

Consider Oil Corporation, a crude oil distribution company that purchases crude oil in three shipments.

The first shipment is three hundred barrels at sixty-three dollars per barrel. The second shipment is three hundred barrels at seventy-two dollars per barrel. The third shipment is three hundred barrels at eighty-four dollars per barrel.

If the company sells four hundred fifty barrels, under LIFO, the sale would consist of three hundred barrels at eighty-four dollars per barrel and one hundred fifty barrels at seventy-two dollars per barrel. This results in a cost of goods sold of thirty-six thousand dollars.

During periods of inflation, LIFO increases the cost of goods sold, lowering the reported net income.

Businesses operating in volatile pricing environments often use LIFO to better align current costs with revenues.