What Is LIFO? Last In, First Out Inventory Method Explained

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LIFO (last in, first out) is an inventory costing method that treats the most recently purchased or produced units as the first ones sold. The newest costs go to cost of goods sold (COGS) on the income statement, and the oldest costs stay in ending inventory on the balance sheet. LIFO is a cost-flow assumption, not a description of how goods physically leave the warehouse. A grocer using LIFO can still ship its oldest milk first.

How LIFO Works

Every inventory method splits the same pool of costs, called goods available for sale, between two places:

Cost of goods sold = Beginning inventory + Purchases − Ending inventory

The method determines which unit costs land in COGS and which remain in ending inventory. Under LIFO, purchases are stacked in “layers” by date. When units are sold, costs are pulled from the top layer (the most recent) and work downward. Whatever layers are left at period end, often including very old ones, make up ending inventory.

Companies apply LIFO in one of two ways:

• Periodic LIFO assigns costs once, at the end of the period, using the last purchases of the whole period.
• Perpetual LIFO assigns costs at each sale, using the latest layer on hand at that moment.

The two can produce different COGS figures when purchases and sales are interleaved during the period, because a sale early in the period cannot draw on a layer bought later.

Worked Example: LIFO vs. FIFO vs. Average Cost

Hypothetical example, periodic system, selling price of $20 per unit.

A retailer’s inventory records for the year:

The retailer sells 250 units, for revenue of $5,000.

LIFO: the 250 units come from the newest layers first.

• 100 units × $15 = $1,500
• 150 units × $12 = $1,800
• COGS = $3,300
• Ending inventory = 50 × $12 + 100 × $10 = $1,600

FIFO: the 250 units come from the oldest layers first.

• 100 × $10 + 150 × $12 = $2,800 COGS
• Ending inventory = 50 × $12 + 100 × $15 = $2,100

Weighted average: $4,900 ÷ 400 units = $12.25 per unit.

• COGS = 250 × $12.25 = $3,062.50
• Ending inventory = 150 × $12.25 = $1,837.50

In every case COGS plus ending inventory equals $4,900. Gross profit is $1,700 under LIFO, $2,200 under FIFO and $1,937.50 under average cost. With an assumed 21% tax rate on that $500 gap, LIFO defers $105 of tax relative to FIFO for this year. The deferral lasts only as long as the low-cost layers stay on the books.

Why Companies Use LIFO

The main reason is tax. In a period of rising input costs, matching the newest (highest) costs against current revenue lowers taxable income, which leaves more cash in the business. That cash benefit shows up in operating cash flow and free cash flow, even though reported earnings look weaker. The gain is largest for businesses that carry big, continuously replenished inventories, such as retailers, auto dealerships and other distributors, and for periods of sustained inflation (see the U.S. inflation rate by year for how cost environments have shifted).

Supporters also argue that LIFO gives a better matching of current costs to current revenue, so gross margin reflects what it actually costs to replace the goods just sold.

The trade-off comes from the LIFO conformity rule in the U.S. tax code (Internal Revenue Code section 472): a company electing LIFO for tax purposes must also use it in reports to shareholders and lenders. It cannot show investors FIFO profits while paying tax on LIFO profits. For a public company, the lower reported earnings can be a real cost, which is one reason many U.S. companies choose FIFO or average cost instead.

Reading LIFO Financial Statements

Because LIFO can leave decades-old costs in inventory, the balance sheet figure may sit far below current replacement value. U.S. companies using LIFO commonly disclose a LIFO reserve:

LIFO reserve = Inventory at FIFO (or current cost) − Inventory at LIFO

In the example above, the reserve is $2,100 − $1,600 = $500. Analysts add the reserve back to inventory to compare a LIFO company with a FIFO peer, and the change in the reserve over a year approximates the difference in COGS between the two methods.

Limitations of LIFO

• Understated inventory. Old cost layers make inventory, current assets and working capital ratios look smaller than economic reality.
• LIFO liquidation. If a company sells more than it buys and dips into old layers, those cheap costs flow into COGS. Profit jumps, and so does the tax bill, often at an inconvenient time such as a downturn or a wind-down of the business. The higher earnings reflect accounting history, not better operations.
• Room for timing decisions. Under periodic LIFO, purchases made near year end change which costs reach COGS, so buying decisions can shift reported profit.
• Reversal in deflation. When costs fall, LIFO produces lower COGS and higher taxable income than FIFO.
• No international acceptance. IAS 2, the IFRS inventory standard, has prohibited LIFO since its 2003 revision (effective 2005). Groups reporting under IFRS cannot use it, and U.S. companies with foreign subsidiaries may have to maintain more than one method. Standard setters’ objections center on inventory values that can drift far from current cost and on the earnings distortions that liquidations cause.
• Valuation rule. Under U.S. GAAP, inventory measured with LIFO (or the retail method) is still written down using lower of cost or market, while FIFO and average cost inventory uses lower of cost and net realizable value. During inflation, LIFO’s low carrying amounts mean write-downs are less frequent.

LIFO vs. FIFO and Related Terms

Neither LIFO nor FIFO is harder to calculate in principle. LIFO does require tracking cost layers over many years, plus the reserve disclosure, which adds recordkeeping. The choice between them depends on whether costs are rising, how large inventory is, whether the company reports under IFRS, and how much weight it gives to reported earnings versus cash taxes. For a deeper look at the expense line both methods feed, see cost of goods sold.

FAQs

The Bottom Line

LIFO matters most to U.S. companies with large, continuously replenished inventories, such as retailers and distributors, during periods of rising costs. It can lower taxable income and keep more cash in the business, but the conformity rule forces weaker reported earnings, and liquidations, deflation and IFRS reporting can erase the benefit. Analysts comparing a LIFO company with a FIFO peer should add the LIFO reserve back to inventory.