What is LIFO (Last In, First Out)?
Last In, First Out (LIFO) Definition
The term “LIFO,” or Last In, First Out, is a method of inventory accounting which expenses inventory in the order of most recently acquired to least recently acquired when calculating the cost of goods sold.
It stands in contrast with FIFO, or first in, first out, which expenses older inventory first.
A company may opt for LIFO if their inventory often undergoes sudden price changes and recent inventory better represents their cost of goods sold.
Example of LIFO
LIFO Cycle, a bicycle manufacturer, buys 100 widgets for $17 each, then 50 for $13 each, then another 50 for $20 each.
LIFO Cycle determines it has sold 100 units for the period.
When calculating their cost of goods sold for the period under LIFO, only the 50 widgets purchased for $20 each and 50 widgets purchased for $13 each will be included, totaling $1,650.
When LIFO Is Used
In periods of falling inventory costs, a company using LIFO will have a greater gross profit because their cost of goods sold is based on more recent, cheaper inventory.
In periods of rising costs, a company will have a lower gross profit because their cost of goods sold is based on more recent, expensive inventory.
Criticisms of LIFO Accounting
The goal of any inventory accounting method is to represent the physical flow of inventory.
Critics of LIFO often claim that it misrepresents the cost of goods sold because most companies try to sell old inventory before new inventory, like in the case of milk at a grocery store.
Because LIFO often does not accurately represent the flow of inventory, companies in the U.S. are required to present an acceptable conversion of inventory accounting, such as first in, first out (or FIFO), and companies using International Financial Reporting Standards are prohibited from using LIFO altogether.