Definition: Last in, first out (LIFO) is an accounting inventory valuation method based on the principal that the last asset acquired (the newest), is the first asset sold.
What Does LIFO Mean?
What is the definition of LIFO?The LIFO method is most commonly applied to an organization’s inventory valuation procedures. There are a lot of different valuation methodologies applied to inventory, and often management has to make a strategic decision to determine the most advantageous method to use. Under LIFO, the valuation is structured around the concept that the last unit of inventory received (the newest inventory) is the first unit of inventory used. Depending on the unit cost and timing of inventory transactions, the LIFO method can generate a number of tax benefits due to profitability impacts on the income statement.
Why is LIFO beneficial? In theory, the cost to purchase inventory will increase over time. The strategy associated with the LIFO valuation method is based on the concept of selling your most expensive inventory first. Upon selling the inventory, the value of the units sold is transferred into the Cost of Sales account and expensed on the company’s income statement.
In other words, more expensive inventory is expensed before less expensive inventory effectively lowering profits and taxable income. This is why most companies choose to use LIFO vs FIFO for valuing their inventory.
Example
Let’s assume you own a retail store and use the first in, first out (FIFO) method of accounting. It’s a profitable business, and you’re looking for ways to reduce your tax burden each year. A business consultant suggests you implement the LIFO inventory method, so you run some numbers.
Let’s say you sell a widget for $5 each. You purchase widgets from a manufacturer, and your purchase cost changes respective to the cost of commodities used in the manufacturing of the widgets. Last week you purchased 100 widgets for $2, and this week you purchased 100 more for $3 due to increasing commodity prices. Let’s take a simple look at how this will impact the income statement if you used the LIFO method of accounting versus the FIFO method of accounting:
| FIFO | LIFO | |
| Sale of 20 Units | $100 | $100 |
| Cost of 20 Units | ($40) – $2 each | ($60) – $3 each |
| Profit Margin | $60 | $40 |
As you can see, the LIFO method of accounting generates less profit, and therefore would reduce the taxable income of the business.
Summary Definition
Define LIFO: Last in, first out means the last in (newest), first out method of inventory valuation.
