Glossary term
Last In, First Out (LIFO)
Last in, first out is an inventory accounting method that treats the most recently acquired goods as sold first for cost-of-goods-sold purposes.
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What Is Last In, First Out?
Last in, first out, or LIFO, is an inventory accounting method that treats the most recently acquired or produced goods as sold first for cost-of-goods-sold purposes. It is a cost-flow assumption, not necessarily a description of the physical flow of goods.
LIFO is most important when inventory costs change over time. In a period of rising costs, LIFO often assigns newer, higher costs to cost of goods sold, which can reduce reported income compared with FIFO.
Key Takeaways
- LIFO assumes the newest inventory costs flow into cost of goods sold first.
- It can reduce taxable income during periods of rising inventory costs.
- LIFO does not have to match the physical movement of goods.
- Businesses using LIFO must follow specific tax and accounting rules.
- The method can make ending inventory values look older than current replacement costs.
How LIFO Works
Suppose a retailer buys 100 units at $10 and later buys 100 more units at $12. If it sells 100 units under LIFO, the cost of goods sold is based on the later $12 cost. The older $10 layer remains in ending inventory.
That treatment can reduce gross profit when costs are rising because more recent, higher costs hit the income statement sooner. When costs are falling, the effect can reverse.
LIFO Compared With FIFO
Method | Cost assigned to goods sold first | Common effect when costs rise |
|---|---|---|
LIFO | Newest inventory costs | Higher cost of goods sold and lower taxable income |
FIFO | Oldest inventory costs | Lower cost of goods sold and higher ending inventory |
What Businesses Should Watch
LIFO can be useful for matching current costs against current revenue, but it also requires careful inventory records. Older inventory layers can accumulate, and financial statements may show inventory values that are well below current replacement costs.
Businesses should also understand the tax rules for adopting and using LIFO. Changing inventory methods generally requires attention to IRS procedures and consistency requirements.
The Bottom Line
LIFO is an inventory cost-flow method that treats the newest costs as sold first. It can affect taxable income, gross margin, and reported inventory values, especially when inventory costs are rising or falling quickly.