The last in, first out (LIFO) method is an inventory costing approach that assumes the most recently purchased items are sold first. Your reported inventory value shapes your bottom line, and the costing method you pick decides how that value lands on your books.
If you want to manage tax exposure when prices climb, the LIFO method is worth understanding. It applies your most recent inventory costs to the goods you sell, which lowers reported profit and defers income tax when prices are rising. This guide covers how the LIFO method works, walks through worked examples, weighs the drawbacks, and explains the accounting rules that govern it.
Key Takeaways
- The LIFO method assumes the newest inventory sells first, so recent, higher costs flow into cost of goods sold when prices rise.
- LIFO lowers taxable income during inflation, but it can understate inventory value on the balance sheet and complicate recordkeeping.
- The LIFO method is permitted in the United States under GAAP and IRS rules, yet banned under International Financial Reporting Standards.
- FIFO and the weighted average cost method are the main alternatives, and the best choice depends on your prices, products, and reporting goals.
What is the LIFO method?
Last in, first out (LIFO) is an inventory valuation method that applies your most recent inventory costs to the goods you sell. You assume the newest items in stock are sold first. You then use that assumption to calculate cost of goods sold (COGS) for financial reports. COGS is the metric that helps you gauge profitability and make informed financial decisions.
To calculate COGS with LIFO, identify your most recent inventory items, find their cost, and multiply by the quantity sold:
COGS = cost of most recent goods x number of goods sold
Because you expense only the newest purchases, older items stay on the books as unsold inventory. That pairs current sales with current costs, so you avoid overstating profit by matching old, low-cost stock against today’s revenue.
According to AccountingTools, LIFO shifts high-cost inventory into COGS to defer income taxes, a benefit that mainly holds up when prices are rising. You can apply LIFO for accounting even if you physically move older stock first.
LIFO method examples
Two quick examples show how the LIFO method plays out in practice.
Example 1: a hardwood dining-table maker
Picture a hardwood dining-table maker that produces 500 tables at $200 each in July, then 400 tables at $250 each in August. It sells 600 tables by the end of September.
Under LIFO, the maker draws COGS from the newest batches first:
- 400 tables from the August batch at $250 each = $100,000
- 200 tables from the July batch at $200 each = $40,000
Total COGS for the dining tables comes to $140,000.
Example 2: a craft cold-brew coffee roaster
Now take a craft cold-brew coffee roaster. In January, it produces 1,000 bottled coffees at $4 each and 500 bottled iced teas at $3 each. In February, it produces 1,200 bottled coffees at $5 each and 600 bottled iced teas at $4 each.
By the end of March, the roaster sells 1,500 bottled coffees and 800 bottled iced teas. Using LIFO, it expenses the most recent inventory first.
Bottled coffee (1,500 sold):
- 1,200 coffees from the February batch at $5 each = $6,000
- 300 coffees from the January batch at $4 each = $1,200
Bottled iced tea (800 sold):
- 600 teas from the February batch at $4 each = $2,400
- 200 teas from the January batch at $3 each = $600
COGS totals $7,200 for bottled coffee and $3,000 for bottled iced tea, so the roaster’s combined COGS equals $10,200.
What are the benefits of the LIFO method?
The LIFO method offers four main advantages when costs are climbing.
1. Maximized tax savings
When prices rise, producing or acquiring inventory costs more. LIFO records those higher, recent costs first, which narrows your profit margin. A smaller margin means a smaller tax bill, so LIFO suits companies that want to ease their tax burden during inflation.
2. Improved cash flow
Trimming your tax liability with LIFO frees up cash that would otherwise go to taxes. You can reinvest it in new equipment, added staff, debt payoff, or other moves that support growth. That flexibility helps you adapt to market shifts and act on opportunities.
3. Optimized inflation accounting
When inflation climbs, matching COGS to current revenue gives a clearer read on expenses and profitability. That accuracy helps you make sound financial decisions and manage resources through tough economic stretches.
4. Better inventory management
If your stock isn’t perishable, LIFO can sharpen how you manage it. Selling the newest items first lets you keep product offerings aligned with current demand. An electronics seller, for instance, can prioritize the latest models buyers expect.
Watch the trade-off, though: the longer older inventory sits unsold, the greater the risk of obsolescence.
What are the disadvantages of the LIFO method?
LIFO isn’t the right fit for every business. Weigh these limitations before you commit:
- Complex recordkeeping: LIFO tracks inventory in cost layers, so the bookkeeping runs more involved than first in, first out or averaging methods.
- Understated inventory value: Because older, cheaper costs stay on the balance sheet, LIFO can make reported inventory look lower than its replacement value.
- LIFO liquidation risk: When you sell more than you restock, old low-cost layers hit COGS, inflating profit and taxes for that period.
- No international acceptance: LIFO isn’t allowed under IFRS, so businesses that report globally can’t use it consistently.
If those drawbacks outweigh the tax benefit, another approach may fit better. The weighted average cost method smooths cost swings across all units, while first in, first out tracks the oldest costs instead. Your decision also depends on whether you run a periodic inventory system or track counts in real time. Either way, compare LIFO against the other common costing methods first.
LIFO’s layered records can also make custom reporting a chore. Fishbowl AI Insights lets your team generate custom inventory and COGS reports in plain language, without SQL or custom report requests.
How does the LIFO method compare to FIFO?
LIFO is the mirror image of FIFO (first in, first out), another common inventory valuation method. With FIFO, you assume the oldest inventory sells first, so the formula flips:
Inventory COGS = cost of oldest goods x number of goods sold
Picture two batches: the first 100 items cost $10 each to make, and the second 100 cost $15 each. Sell 100 units under FIFO and you expense the first batch, giving a COGS of $1,000. Run the same sale under LIFO and you expense the newer batch, giving a COGS of $1,500.
Many industries default to FIFO because it mirrors how they move stock and is recognized worldwide. FIFO usually reports a lower COGS, so LIFO wins only when a higher COGS serves your goals better.
Is the LIFO method banned, and why?
LIFO is permitted in the United States but barred across most of the world. The divide comes down to which accounting standards a country follows.
The KPMG IFRS Institute notes that IAS 2 prohibits LIFO because the International Accounting Standards Board found it does not faithfully represent inventory flow patterns. Countries on International Financial Reporting Standards (IFRS) therefore rule it out.
The United States uses Generally Accepted Accounting Principles (GAAP), which still allow LIFO. Most U.S. companies use FIFO or weighted average, though some choose LIFO for its tax treatment.
Track LIFO costs with Fishbowl
Once you pick a valuation method, you need a system that tracks costs accurately. Whether you use LIFO, FIFO, or another approach, Fishbowl’s inventory platform keeps your numbers straight.
With built-in QuickBooks and Xero sync, Fishbowl values inventory precisely and keeps operations and accounting aligned. The system enforces accurate stock counts, so your COGS and financial reports stay reliable.
Prince Michel Vineyard & Winery shows the payoff. After adopting Fishbowl Manufacturing, the winery cut its cost-to-manufacture calculations from six months after year-end to immediately upon manufacture. It also improved accuracy by more than 10%.
Book a Demo to see how Fishbowl brings inventory, costing, and accounting into one system.
Frequently asked questions about the LIFO method
Which inventory method is best for a small retailer?
It depends on your prices and products. Small retailers with steady or falling costs often prefer FIFO, which keeps inventory values close to replacement cost and is accepted worldwide. If costs are rising and you want to defer taxes, LIFO can help, though it complicates your records. The weighted average cost method sits in the middle, smoothing price swings across all units. Sellers of perishable goods usually favor FIFO to match how stock physically moves.
Is LIFO allowed under GAAP and IFRS?
LIFO is allowed under U.S. GAAP but prohibited under IFRS. As the KPMG IFRS Institute explains, IAS 2 bars LIFO because standard-setters concluded it can misrepresent how inventory actually moves. Businesses reporting under IFRS, which covers most countries outside the United States, cannot use it. U.S. companies can still elect LIFO, and many do for the tax advantages it offers when prices climb.
What are the IRS rules for using LIFO?
In the United States, you elect LIFO by filing Form 970 with your tax return. The IRS confirms that Form 970 lets you elect the last-in, first-out inventory method described in section 472 of the tax code. Once you adopt LIFO, the election is irrevocable unless the IRS approves a change. Separately, AccountingTools notes a LIFO conformity rule: if you use LIFO to compile taxable income, you must also use it in your financial statements.
What is a LIFO reserve?
A LIFO reserve is the gap between inventory valued under LIFO and its value under FIFO or another method. AccountingTools defines it this way. The reserve shows how much LIFO has lowered your reported inventory and profit over time. Accountants track it to compare companies that use different costing methods and to estimate the tax impact of moving away from LIFO.
How does LIFO liquidation affect financials?
LIFO liquidation happens when you sell more inventory than you replace, so old, low-cost layers flow into COGS. Because those layers are cheaper than current costs, your COGS drops and your reported profit jumps. That spike also raises your tax bill for the period, which offsets LIFO’s usual tax advantage. Liquidation often signals shrinking inventory, so it’s worth watching if you run lean stock levels.
Related posts
- The FIFO Method: First In First Out Explained
- Costing Methods for Inventory and Manufacturing Management: Types & Examples
- Cost of Goods Sold (COGS): How to Calculate & Explanation
- Weighted average cost inventory method: A complete guide
- Unveiling inventory valuation methods: A comprehensive guide
- What’s a Periodic Inventory System? How It Works and Examples