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The cost of inventory can have a significant impact on your profitability, which is why it’s important to understand how much you spend on it. With an inventory accounting method, such as last-in, first-out (LIFO), you can do just that. Below, we’ll dive deeper into LIFO method to help you decide if it makes sense for your small business.
The LIFO Method
LIFO is a method used to account for inventory. It’s only permitted in the United States and assumes that the most recent items placed into your inventory are the first items sold. Under LIFO, you’ll leave your old inventory costs on your balance sheet and expense the latest inventory costs in the cost of goods sold (COGS) calculation first. While the LIFO method may lower profits for your business, it can also minimize your taxable income. As long as your inventory costs increase over time, you can enjoy substantial tax savings.
LIFO vs. FIFO
While LIFO is an acronym for last-in, first-out, FIFO stands for first-in, first-out. The LIFO method is based on the idea that the most recent products in your inventory will be sold first. The FIFO method is the opposite as it assumes the oldest products in your inventory will be sold first and uses those lower cost numbers when calculating COGS.
In most cases, LIFO will result in lower closing inventory and a larger COGS. FIFO differs in that it leads to a higher closing inventory and a smaller COGS. LIFO is more popular among businesses with large inventories so that they can reap the benefits of higher cash flows and lower taxes when prices are rising.
FIFO is more common, however, because it’s an internationally-approved accounting methos and businesses generally want to sell oldest inventory first before bringing in new stock.
Benefits of LIFO
The most noteworthy advantages of LIFO include:
- Tax savings. If the cost of your products increases over time, the LIFO method can help you save on taxes. This is because applying the most recent or higher inventory costs to the items you’ve sold will cause your profit margin to go down. The lower your profits, the less you’ll owe in taxes. Depending on your unique business and finances, this can lead to significant tax savings over time.
- More current financial data. The LIFO method requires you to apply your most recent inventory costs to COGS first. When you do so, you’ll give yourself and your investors an accurate look at how you’re currently doing financially. You’ll be able to easily compare your current inventory costs against your current revenue.
- Positive customer experience. If you follow the LIFO method and fulfill orders using your most recent inventory, you’re more likely to provide your customers with a better experience. This can lead to repeat business and improve your reputation.
When to Use LIFO
LIFO might be a good option if you operate in the U.S. and the costs of your inventory are increasing or are likely to go up in the future. By using this method, you’ll assume the most recently produced or purchased items were sold first, resulting in higher costs and lower profits, all while reducing your tax liability. LIFO is often used by gas and oil companies, retailers and car dealerships.
LIFO Examples
By looking at a few examples of LIFO in action, you can get a better idea of how it would work if your business goes this route.
EXAMPLE A
In January, Kelly’s Flower Shop purchases 100 exotic flowering plants for $25 each and 50 rose bushes for $15 each. Once March rolls around, it purchases 25 more flowering plants for $30 each and 125 more rose bushes for $20 each. It sells 50 exotic plants and 25 rose bushes during the first quarter of the year for a total of 75 items.
If Kelly’s Flower Shop uses LIFO, it will calculate COGS based on the price of the items it purchased in March.
Here’s what the calculation would look like:
COGS = 30 exotic flowering plants x $25 ($750) + 25 exotic flowering plants x $25 ($625) + 25 rose bushes x $20 ($500) = $1,875
EXAMPLE B
Andy’s Woodshop sells wooden figurines. His business has been doing well, resulting in larger inventory orders and better bulk pricing from suppliers. Andy decides to go to a local craft fair and bring his entire stock of 30 figurines. He takes the following three orders with him:
- Order 1: 5 wooden figurines valued at $30 each
- Order 2: 10 wooden figurines valued at $25 each
- Order 3: 15 wooden figurines valued at $20 each
Andy succeeds at the craft fair and sells 20 of his 30 wooden figurines. He uses the LIFO method to determine his COGS. This means he assumes he sold all 15 figurines from order 3 and five from order 2. Here’s a look at his math under LIFO:
COGS = (15 figurines x $20) + (5 figurines x $25) = $300 + $125 = $425
Bottom Line
The LIFO method reduces your profit margins and in turn reduces your taxable income. Before you implement it, however, understand that lower profit margins can be problematic if you apply for credit or funding. Also, LIFO is only allowed in the U.S. so if you’re an international business, it won’t be an option.
Frequently Asked Questions
What Is LIFO Reserve?
LIFO reserve refers to the amount by which your business’s taxable income has been reduced as compared to the FIFO method. It can show you whether LIFO was worth it for the tax savings.
Is LIFO Legal?
LIFO is only legal in the U.S. Therefore, if you have an international business that operates outside of the U.S, you should stick to FIFO instead.
