What is last in first out (LIFO) in accounting?
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In inventory management, efficient and accurate methods are crucial for businesses to thrive. One such method is LIFO, or Last-In, First-Out. This inventory valuation approach offers a strategic way to manage stock and financial reporting.
In this guide, we will delve into the concept of LIFO, its advantages, and its applications across various industries.
What is LIFO?
LIFO is an inventory management method that assumes that the most recently produced items are sold first. This means businesses calculate the cost of goods sold using the most recent prices of the items in inventory. The LIFO method works by adding new items to the back of an inventory stack while older items remain at the front. When the business sells an item, it takes it from the front of the stack, meaning that the last item added is always the first one sold.
Last in, first out: example and formula
To better understand how LIFO accounting works, imagine that an electronics business purchases 100 units of a gadget at $10 each. The total cost for this initial inventory is $1,000 ($10 x 100 units).
In a few weeks, the gadget's price increases due to market fluctuation. You acquire another 100 units, but this time at $12 each. The total cost for this batch of inventory is $1,200 ($12 x 100 units).
Now, you have 200 units in your inventory, with a combined cost of $2,200 ($1,000 + $1,200).
You then sell 150 units of the gadget to customers. According to the LIFO method, the business assumes that it sold the 100 units bought at $12 first and then 50 units bought at $10.
Using the LIFO method, you can calculate the cost of goods sold (COGS) as follows:
- 100 units sold at $12 each = $1,200
- 50 units sold at $10 each = $500
- Total COGS = $1,700 ($1,200 + $500)
Now let's assume that you sold each gadget for $15. The total revenue for selling 150 units would be $2,250 ($15 x 150 units).
To calculate the gross profit, subtract the COGS from the total revenue:
Total Revenue ($2,250) - COGS ($1,700) = Gross Profit ($550)
After selling 150 units, you have 50 units remaining in your inventory. According to LIFO, these are the oldest items purchased at $10 each.
The total value of the remaining inventory is $500 ($10 x 50 units).
In this example, the LIFO accounting method results in a higher cost of goods sold ($1,700) and a lower gross profit ($550) compared to other inventory valuation methods like First-In, First-Out (FIFO). This can be advantageous for businesses seeking to reduce their taxable income and improve cash flow, especially during periods of rising costs or inflation.
For investors or lenders of a business, it is critical to understand if a business is using LIFO or FIFO accounting convention, since it can tell a drastically different story around margin trajectory, and the health of a business (as shown in the example above).
Advantages of LIFO
LIFO offers several benefits that make it an attractive choice for businesses, including:
Mitigating inflation impact
LIFO can help your business minimize the impact on its inventory valuation during inflation. This is because LIFO prioritizes selling the most recent, higher-priced items first. As a result, the cost of goods sold (COGS) increases, leading to a lower taxable income.
For example, during an economic upturn, raw materials and finished goods prices may rise. By using LIFO, your business can ensure that it sells its most expensive stock first, thereby reducing the overall effect of inflation on its financial statements.
Improved cash flow
Using LIFO allows your business to strategically manage its finances, particularly during economic uncertainty or when facing cash flow constraints.
By selling the most recent items first, your business reports a higher cost of goods sold (COGS). This results in lower gross profits and, consequently, lower taxable income. Lower taxable income means a reduced tax liability, leaving more cash in your business's coffers.
This improved cash flow can be a lifeline during economic uncertainty, providing you with extra resources to reinvest in your business, pay off debts, or distribute dividends to shareholders.
Streamlined inventory management
The LIFO accounting method encourages businesses to sell the newest stock first, which can be especially beneficial in industries where items have a short shelf life or are sensitive to technological obsolescence.
For instance, products can quickly become outdated in the technology industry due to rapid advancements and innovation. By employing LIFO, tech companies can ensure they're selling their most recent inventory before it loses value or becomes obsolete. Similarly, businesses dealing with perishable goods, such as food and beverages, can benefit from LIFO as it helps prevent spoilage and waste by prioritizing the sale of newer items.
Limitations of LIFO
While the LIFO (Last-In, First-Out) inventory management method offers several advantages to businesses, it also has some limitations you must consider:
Incompatibility with IFRS
The International Financial Reporting Standards (IFRS) is a globally recognized set of accounting standards that provides transparency and consistency in financial reporting. However, the IFRS does not permit using the LIFO method for inventory valuation.
This limitation may create challenges for businesses operating internationally or preparing financial statements under IFRS. Companies using LIFO might have to prepare separate financial statements using an alternative inventory valuation method, such as FIFO (First-In, First-Out), which can be cumbersome and time-consuming.
LIFO prioritizes selling the newest stock first, which means older items may remain in inventory for extended periods. This can lead to potential obsolescence or spoilage, particularly in industries where products have a short shelf life or are susceptible to rapid technological advancements.
For example, businesses dealing with perishable goods, such as food and beverages, might face spoilage and waste issues if older items remain unsold for too long. Similarly, in the technology industry, older items might quickly become outdated due to rapid innovation, rendering them less valuable or unsellable. This limitation of LIFO requires businesses to closely monitor their inventory levels and consider additional strategies to manage potential obsolescence or spoilage.
The LIFO method requires tracking inventory costs for each item over time. This involves keeping detailed records of inventory purchases, cost layers, and sales transactions for every product in stock. Maintaining accurate LIFO records can strain a company's resources and increase the likelihood of errors in inventory valuation.
Furthermore, implementing and maintaining a consistent LIFO approach across all facilities can be particularly challenging if a company operates in multiple locations or countries.
Keep track of your inventory with Ramp
Managing your inventory is crucial for the success and growth of your business. At Ramp, we provide a comprehensive and automated finance platform to help you track your inventory accurately. Our accounting automation allows you to effortlessly streamline inventory tracking by managing data, reconciling transactions, and generating reports. With Ramp, you can gain insights into your inventory performance and keep track of your costs in real time.
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