Last-In, First-Out
LIFOLast-In, First-Out (LIFO) is an inventory management method that assumes the last items added to stock are the first ones to be sold or used.
Last-In, First-Out (LIFO) is a method for inventory accounting and valuation. It operates on the principle that the most recently acquired materials or products are sold first. This means the cost of the latest inventory purchased is the first to be recorded as Cost of Goods Sold (COGS). LIFO contrasts with the First-In, First-Out (FIFO) method, which assumes the oldest inventory is sold first.
On the shop floor, LIFO often reflects the physical reality of storing bulk materials. For example, a pile of sand, coal, or gravel is loaded from the top. The newest material is on top and is the easiest to access and use first. The older material remains at the bottom of the pile. This method is suitable for homogenous products that do not expire or degrade over time.
From a financial perspective, LIFO has significant implications during periods of rising prices (inflation). By matching the most recent (and higher) costs against current revenues, LIFO results in a higher COGS. This leads to lower reported profits and a reduced income tax liability. While permitted under U.S. Generally Accepted Accounting Principles (GAAP), LIFO is prohibited by International Financial Reporting Standards (IFRS).
A metal fabricator stores steel bars in a large bin. In January, they buy 100 bars at $50 each. In February, they buy another 100 bars at $55 each, placing them on top of the January stock. When a work order requires 50 bars, they use the newest ones from the February purchase, recording a COGS of $2,750 (50 bars x $55).
What is the main difference between LIFO and FIFO?
LIFO assumes the newest inventory is sold first, while FIFO assumes the oldest inventory is sold first. This choice affects the valuation of remaining inventory and the Cost of Goods Sold.
When is LIFO a good inventory method for a manufacturer?
LIFO is useful for homogenous, non-perishable bulk goods where the newest items are most accessible. It is also used during periods of inflation to match current costs with current revenues, which can lower taxable income.
Does LIFO reflect the actual physical flow of goods?
Sometimes. For bulk materials like gravel or coal, it often matches the physical flow. However, LIFO is primarily an accounting convention and does not need to match the physical movement of inventory.
What are the disadvantages of using LIFO?
LIFO can report outdated inventory values on the balance sheet, as the remaining stock is valued at older costs. It is also not permitted under International Financial Reporting Standards (IFRS), limiting its use for global companies.
How does LIFO affect the Cost of Goods Sold (COGS)?
During periods of rising costs, LIFO increases COGS because it expenses the most recently purchased, higher-cost items first. This results in lower reported net income compared to FIFO.
First-In, First-Out
FIFOFirst-In, First-Out (FIFO) is an inventory management method where the first materials received are the first ones used in production or shipped.
Cost of Goods Sold
COGSCost of Goods Sold (COGS) represents the direct costs of producing the goods sold by a business.
Inventory Turnover Ratio
The inventory turnover ratio measures how many times a company sells and replaces its inventory over a specific period.
Warehouse Management System
WMSA Warehouse Management System (WMS) is software that directs and optimizes warehouse operations from receiving to shipping.
Economic Order Quantity
EOQEconomic Order Quantity (EOQ) is the ideal order size a company should purchase to minimize its total inventory costs, including holding and ordering costs.