Last In, First Out (LIFO), Work, Advantages, Disadvantages

Last In, First Out (LIFO) is one of the inventory valuation methods used in accounting. It assumes that the most recently acquired items (the last in) are the first to be sold or used (the first out). This method contrasts with First In, First Out (FIFO), which assumes that the oldest items are sold first. LIFO has unique implications for businesses, especially in environments where prices are volatile.

How LIFO Works?

Under the LIFO method, the inventory that was most recently purchased or produced is assumed to be sold first. This means that the newest inventory is the first to be used up or sold in the course of business, while older inventory remains in stock.

For example, if a company buys 100 units of a product at $10 each in January, 150 units at $12 each in March, and 200 units at $14 each in June, and it sells 200 units in July, the LIFO method dictates that the 200 most recent units bought (in this case, the 150 units at $12 and 50 units at $14) are sold first.

Calculation Example:

1. Purchases:
   • January: 100 units at $10 each
   • March: 150 units at $12 each
   • June: 200 units at $14 each
2. Sales (200 units sold in July):
   • 150 units from the June purchase at $14
   • 50 units from the March purchase at $12

Thus, the Cost of Goods Sold (COGS) under LIFO would be calculated as:

• 150 units x $14 = $2,100
• 50 units x $12 = $600

The total COGS for the 200 units sold is $2,700.

After the sale, the remaining inventory would consist of:

• 100 units from January at $10
• 100 units from March at $12

Thus, the remaining inventory would be valued as:

• 100 units x $10 = $1,000
• 100 units x $12 = $1,200

The total value of remaining inventory is $2,200.

Advantages of LIFO

• Lower Tax Liabilities in Inflationary Environments:

In times of inflation, the cost of newer inventory will be higher than that of older inventory. Since LIFO assumes that the most recently purchased (and thus more expensive) goods are sold first, it results in a higher COGS, which reduces taxable profits. As a result, businesses can pay lower taxes.

• Better Matching of Current Costs with Revenues:

LIFO provides a more accurate matching of current costs with current revenues. Since the most recent (and often higher) costs are matched with sales, LIFO ensures that the expense reflects current market conditions.

• Inventory Valuation Reflecting Older Costs:

As older inventory remains on the balance sheet under LIFO, the value of inventory may be understated, reflecting the original purchase price rather than current market prices. In industries where inventory is held long-term or purchased in large volumes, this method helps maintain consistency in the valuation of older items.

• Cash Flow Advantages:

By reducing taxable income, LIFO can help businesses conserve cash, which can be used for reinvestment, paying off debt, or expanding operations. This is especially useful for companies that operate in high-inflation markets.

Disadvantages of LIFO

• Reduced Profits in Inflationary Times:

Although LIFO lowers tax liabilities, it also reduces profits, since higher costs are matched against revenues. This could make a company appear less profitable, which might be a disadvantage when seeking financing or attracting investors.

• Not Allowed Under IFRS:

One of the significant disadvantages of LIFO is that it is not permitted under International Financial Reporting Standards (IFRS). This limits its use in international operations or by companies that need to comply with these standards. Many countries outside the United States have adopted IFRS, making LIFO less viable for global businesses.

• Inventory Valuation May Be Distorted:

The inventory left on the balance sheet using LIFO may not represent current market values, especially if a company holds inventory for a long time. As older inventory items accumulate on the books, they may be valued at outdated prices, distorting the company’s actual financial position.

• Complicated Record-Keeping:

LIFO requires meticulous record-keeping, as businesses need to track the costs of the most recent purchases separately from older ones. This can result in higher administrative costs, especially for companies with large volumes of inventory.

• May Not Reflect Physical Flow of Goods:

LIFO does not always reflect the actual physical flow of goods. For example, in a grocery store, fresh produce (often bought at higher prices) is sold first, but LIFO would imply that older, lower-cost goods are sold first. This can create discrepancies between the way the business operates and the accounting treatment.

LIFO in Practice:

LIFO is particularly useful in industries where prices fluctuate frequently, especially during inflationary periods. Some examples are:

• Manufacturing:

In manufacturing industries, where raw materials and components are constantly bought at fluctuating prices, LIFO can help align the cost of goods sold with the most current cost of materials.

• Mining and Energy:

Mining companies and energy providers that deal with raw materials or commodities like oil, gas, and metals often use LIFO to match current costs with revenues, especially when prices are rising.

• Retail:

Retail businesses that deal with non-perishable goods and have large inventories may also use LIFO to account for changes in inventory costs. This is especially true for retailers who purchase large quantities of inventory at once.