Your reported inventory value has a massive impact on your company’s bottom line. But with so many valuation methods to choose from, how do you know which one is ideal for your company?
If you want to maximize tax benefits and keep costs in check, the last in, first out (LIFO) method is worth exploring. LIFO allows you to use the most recent inventory costs for your cost of goods sold, reducing your taxable income and saving you money.
Keep reading to learn how the LIFO inventory method works and how it could benefit your company.
What is LIFO?
With the LIFO method, you assume the newest items in your inventory are the first to be sold or used, then use this assumption when calculating the cost of goods sold (COGS) — a metric that helps you assess profitability and make informed financial decisions — for financial reports.
To calculate COGS with LIFO, identify the most recent inventory items, calculate their cost, and multiply their cost by the quantity sold with this LIFO equation:
COGS = Cost of most recent goods x Number of goods sold
Since you’re only expensing the most recent items in inventory, you can report older items as unsold inventory. This means the expenses recorded on financial statements correspond with the revenue generated during the same period. You won’t be overstating your profits by matching older, lower-cost inventory with current sales.
You can use LIFO for accounting purposes regardless of how you manage inventory. Some businesses would have to sell inventory in the order it’s produced because it’s perishable, but they can still benefit financially from LIFO. However, LIFO is only accepted in the U.S. It’s approved under GAAP’s financial reporting standards but not under the International Financial Reporting Standards (IFRS).
LIFO examples
Still trying to figure out how to do LIFO? Here are two examples to clear up confusion.
Example 1: Frank’s Furniture
Say that Frank’s Furniture manufactured a batch of 500 dining tables at $200 each in July. It produced another batch of 400 dining tables at $250 each in August. Frank’s Furniture sold 600 dining tables by the end of September.
Using LIFO, Frank’s Furniture would calculate its COGS like this:
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Dining tables sold (600 total)
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400 tables from the August batch at $250 each = $100,000
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200 tables from the July batch at $200 each = $40,000
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The COGS for dining tables would total $140,000.
Example 2: Betty’s Brews
Imagine you run a beverage manufacturing business called Betty’s Brews. In January, you produce a batch of 1,000 bottled coffee drinks at $4 each and 500 bottles of iced tea at $3 each. In February, you produce another batch of 1,200 bottled coffee drinks at $5 each and 600 bottles of iced tea at $4 each. By the end of March, you sell 1,500 bottled coffee drinks and 800 bottles of iced tea.
To calculate COGS using LIFO, Betty’s Brews needs to expense the most recent inventory first:
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Bottled coffee drinks sold (1,500 total)
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1,200 drinks from the February batch at $5 each = $6,000
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300 drinks from the January batch at $4 each = $1,200
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Bottles of iced tea sold (800 total)
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600 bottles from the February batch at $4 each = $2,400
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200 bottles from the January batch at $3 each = $600
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The COGS for bottled coffee drinks would total $7,200 and for bottles of iced tea, COGS would total $3,000. This means Betty’s Brews’ total COGS would equal $10,200.
LIFO versus FIFO
LIFO is the opposite of FIFO (first in, first out), another common inventory valuation method. Using the FIFO method, you assume your company sells the oldest inventory items first. When calculating COGS with FIFO, follow this formula:
Inventory COGS = Cost of oldest goods x Number of goods sold
Here’s an example of FIFO to show the difference: Imagine you have two batches of inventory. The first 100 items cost $10 per item to manufacture, and the second 100 items cost $15 per item. With FIFO, if you sold 100 items of inventory, you’d expense only the first batch, giving you a COGS of $1,000 (100 items x $10). With LIFO, you’d expense the second batch first, giving you a COGS of $1,500 (100 items x $15).
Many industries default to FIFO because it reflects how they move inventory and is recognized internationally. But FIFO typically results in a lower COGS, meaning that, despite the benefits, LIFO beats out FIFO in situations when reporting a higher COGS is better.
4 benefits of LIFO
Here are four ways your company could benefit from LIFO.
1. Maximized tax savings
When prices rise, the cost of producing or acquiring inventory is bound to go up, making it challenging to manage tax liabilities. But with LIFO, you offset this by first recording the recently acquired, higher costs on financial statements. This narrows your profit margin, which may sound like a drawback — but when profits are lower, so is your tax liability. This makes LIFO suitable for companies looking to reduce the tax burden when inflation drives up costs.
2. Improved cash flow
Reducing your tax liability with LIFO frees up funds that would otherwise go toward taxes. You can then re-invest this cash in your company. For example, you can purchase new equipment, expand your workforce, pay off debt, or make other moves that strengthen your business and support its growth. In this way, LIFO provides enough financial flexibility to improve operations, adapt to market changes, or seize opportunities as they arise.
3. Optimized inflation accounting
When inflation is on the rise, matching your COGS with current revenues with LIFO provides a more accurate picture of your expenses and profitability. This allows you to make more informed decisions about your company’s finances and manage resources during challenging economic circumstances.
4. Better inventory management
If your company’s inventory isn’t perishable or time-sensitive, LIFO helps you manage stock more effectively. Since LIFO encourages you to sell the newest inventory items first, you can tailor product offerings to meet current trends and market demands as they evolve.
For example, if you sell electronics, prioritizing the sale of the latest models would help you meet customer expectations for cutting-edge technology. However, this benefit may not apply if your product line never changes, and it’s important to note that the risk of obsolescence increases the longer that inventory items sit on shelves unsold.
Optimize your inventory management with Fishbowl
Once you settle on an inventory valuation strategy, you’ll need an inventory management system to keep track of costs. Whether you use LIFO or another method, Fishbowl can help.
With seamless QuickBooks integration, Fishbowl makes it easy to value inventory with precision, optimize inventory management, and streamline operations. Unlock the full potential of your business with Fishbowl. Book a demo to experience a new level of efficiency and control today.