What is Last In First Out (LIFO)? Definition
LIFO is an inventory valuation method in which the most recently acquired items are assumed to be the first ones sold. The acronym LIFO stands for “last in, first out.” LIFO is used by businesses to manage inventory levels and costs. It can also be used to manage other assets, such as raw materials and finished goods. When a business uses LIFO, it records the most recent items first and the earliest items last. This means that the business will sell the most recent items first and the earliest items last. This inventory valuation method is different from other methods, such as FIFO (first in, first out) and WAC (weighted average cost).
What is LIFO?
In accounting, LIFO (last in, first out) is a method used to value and record inventory. Under LIFO, the most recent items added to inventory are assumed to be the first items sold. The cost of goods sold is based on the costs of the most recent items purchased or manufactured. The remaining inventory is valued at these same costs.
LIFO assumes that inventory on hand consists of the most recent items purchased or manufactured. When inventory is valued using LIFO, this assumption affects both the cost of goods sold and the value of ending inventory. As a result, LIFO often does not reflect the actual physical flow of goods.
How Does LIFO Work?
LIFO is an inventory valuation method in which the last items added to inventory are the first ones sold. The rationale behind LIFO is that costs rise over time, so the items with the highest costs are typically the most recently purchased.
LIFO can be used in conjunction with other methods, such as FIFO (first-in, first-out) or weighted average. However, LIFO must be used if required by generally accepted accounting principles (GAAP).
To illustrate how LIFO works, let’s say a company has 100 widgets in inventory at the beginning of the year. During the year, the company purchases 200 additional widgets at a cost of $5 each. At the end of the year, 100 widgets are sold.
Under LIFO, the 100 widgets sold would be those that were purchased last year at a cost of $5 each. The remaining 100 widgets in inventory would have a cost of $4 each (the original purchase price from this year). Therefore, Inventory = $400 and Cost of Goods Sold = $500 under LIFO.
Advantages of LIFO
There are a few advantages of using the Last In First Out method:
1. It is simple to understand and easy to implement.
2. It generally results in lower inventory levels, which can lead to cost savings.
3. It can match current sales demand more effectively than other inventory methods, such as First In First Out (FIFO).
4. Under certain conditions, it can provide a better estimate of ending inventory levels and cost of goods sold (COGS).
Disadvantages of LIFO
The main disadvantage of LIFO is that it can lead to inaccurate inventory valuation. This is because the costs associated with the oldest items in inventory are assigned to the newest sales, which may not reflect the true cost of goods sold.
Another disadvantage of LIFO is that it can create artificial shortages. This happens when the demand for a product exceeds the supply of that product, but there are still older products in inventory that have not been sold. The artificial shortage can lead to lost sales and disgruntled customers.
Conclusion
LIFO is a method used in accounting to value inventory. Inventories are generally valued using the first in, first out (FIFO) method, but LIFO may be used under certain circumstances. LIFO can provide some benefits over FIFO, but it also has some drawbacks that should be considered before adopting this method.