There are many different inventory-costing methods that your business may choose to use, including first in, first out (FIFO) and the average cost method. However, another inventory-costing method that you need to pay attention to is last in, first out (LIFO). Find out everything you need to know about the LIFO inventory method with our comprehensive guide.
Understanding the LIFO method
Last in, first out (LIFO) is an inventory valuation method that assumes the most recent products added to your inventory will be the first to be sold. Under the LIFO method, the cost of the most recent products that your business has purchased (or produced) are the first expensed in your cost of goods sold (COGS) calculation. This means that you'll report the lower cost of the older products as inventory, which can lead to lower taxes.
How does LIFO accounting work?
It's important to note that LIFO is an inventory-costing method used exclusively in the United States. This is because while it is allowed under the Generally Accepted Accounting Principles (GAAP), the much more widely used International Financial Reporting Standards (IFRS) forbids companies from using the last in, first out method. As such, if you're planning on expanding globally – or you're already in the process of doing so – the LIFO method may not be the best fit.
Furthermore, electing to use the LIFO method can be relatively complex. If you're using FIFO, you'll need to file Form 970 with the IRS to make the switch. You'll be required to specify which goods LIFO will apply to, identify the inventory methods you've previously used for these goods, and explain what the LIFO method won't be used for. Once you've started using LIFO accounting, you're not allowed to go back to another inventory-costing method unless you get approval from the IRS.
Last in, first out in practice
LIFO accounting can be very complicated. Consequently, it may help to look at a LIFO example to see how this inventory-costing method works in the real world.
Imagine that your business purchased 100 faucets one year ago at a per-unit price of around $10. Then, one week ago, you bought a second set of taps at an increased cost of $15. Which goods should you start selling first? With the LIFO inventory method, you'll sell the $15 faucets first, as this allows you to retain the less expensive faucets in inventory.
Still with us? Good, here's the simple part. When it's time to calculate your inventory (for tax purposes), the LIFO method allows you to value your remaining stock at a lower amount. This is because you'll have a disproportionate number of cheaper items in your inventory. Consequently, you'll end up paying less in corporate taxes, boosting your bottom line.
LIFO vs. FIFO: what's the difference?
When it comes to LIFO vs. FIFO, there are a few clear differences. Whereas LIFO stands for last in, first out, FIFO stands for first in, first out. In other words, FIFO assumes that the first products added to your inventory will be the first sold (i.e., you sell your oldest products first). This means that you'll use the lower cost numbers in your COGS calculation. Typically, the LIFO inventory method will lead to lower closing inventory and a larger cost of goods sold, while with FIFO, it will be the reverse.
Is LIFO accounting the right choice for my business?
While the last in, first out method can lead to lower taxes, it's also likely to make your bookkeeping far more complex. Furthermore, in many cases, the LIFO method doesn't accurately represent your inventory's real cost. This is because it's linked to inventory totals, rather than your physical inventory. Consequently, many authorities consider the LIFO inventory method to be untrustworthy, which is why the IFRS doesn't accept it, and the majority of U.S. companies tend to stick with the FIFO method.
Having said that, the tax breaks and higher cash flows associated with LIFO accounting make it a somewhat popular choice among businesses with extensive inventories (such as retailers or car dealerships). If your business deals with a relatively large inventory, then last in, first out accounting could suit your needs.
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