Under LIFO, each item you sell will increase your Cost of Goods Sold (COGS) by the value of the most recent inventory you purchased. The value of your ending inventory is then calculated based on your oldest inventory.
Since most retailers are looking to sell their oldest stock first, the LIFO method is unintuitive. But in some cases, it can make your business look more profitable or be a better representation of how your business operates.
How LIFO works (an example)
Sylvia’s Platters sells artisan kitchenwares. Lately, her business has been picking up, which means bigger inventory orders, and better bulk pricing from suppliers.
A big craft fair is coming into town and Sylvia is going to take her entire stock. She has 3 recent inventory orders that she received that she’ll be taking to the craft fair:
- Order 1 was for 5 platters at $30 a platter
- Order 2 was for 10 platters at $25 a platter
- Order 3 was for 15 platters at $20 a platter
At the craft fair, Sylvia’s Platters is a big hit and she sells 20 of the 30 platters she brought. Before she calls the craft show a big success, Sylvia wants to calculate her net income from the event. Sylvia uses the LIFO method to figure out her Cost of Goods Sold.
Sylvia assumes she sold her most recent inventory first. So the 20 platters she sold are made up of 15 platters from Order 3 and 5 from Order 2.
Sylvia’s Cost of Goods Sold = (15 platters x $20) + (5 platters x $25)
Sylvia’s Cost of Goods Sold = $300 + $125 = $425
The same example using First In, First Out (FIFO)
What if Sylvia used the more common First In, First Out method?
Instead of assuming she sold her most recent inventory first, Sylvia assumes she sold her oldest inventory first. The 20 platters she sold are made up of 5 platters from Order 1, 10 platters from Order 2, and 5 platters from Order 3.
Sylvia’s Cost of Goods Sold = (5 platters x $30) + (10 platters x $25) + (5 platters x $20)
Sylvia’s Cost of Goods Sold = $150 + $250 + $100 = $500
Because Sylvia’s cost per platter is going down with each order, her Cost of Goods Sold is higher with the FIFO method than the LIFO method.
LIFO method and inventory valuation
Since Sylvia has 10 platters left, she will calculate the value of her remaining inventory. To do this, she needs to add up the costs of the 10 platters she has left. She assumes the 10 platters are the following:
- 5 platters left from Order 1 at $30 a platter
- 5 platters left from Order 2 at $25 a platter
Sylvia’s ending inventory = (5 platters x $30) + (5 platters x $25)
Sylvia’s ending inventory = $150 + $125 = $275
Because Sylvia’s cost per platter is going down, she will always be counting the most expensive inventory as what’s left over. This will keep her inventory valuation high.
Why use the LIFO method?
Your inventory valuation method will affect two key financial statements: the income statement and balance sheet.
If your inventory costs are increasing over time, using the LIFO method will mean counting the most expensive inventory first. Your Cost of Goods Sold would be higher and your net income will be lower. Your leftover inventory will be your oldest, cheapest stock, meaning a higher inventory value on your balance sheet. If your business is looking to reduce its net income (and with it, your tax bill), the LIFO method will benefit you here.
But if your inventory costs are decreasing over time, using the LIFO method will mean counting the cheapest inventory first. Your Cost of Goods Sold would be lower and your net income will be higher. Your leftover inventory will be your oldest, more expensive stock meaning a higher inventory value on your balance sheet. For businesses looking for funding from loans or investors, this will make your business seem higher performing. By increasing your net income and the value of your assets, your business looks more desirable for funding.
If your inventory costs don’t really change, your method of inventory valuation won’t seem important. If all your inventory costs stay the same, there would be no effect on how you calculate your Cost of Goods Sold or ending inventory. But it matters to the IRS.
Whether your inventory costs are changing or not, the IRS requires you to choose a method of accounting for inventory that’s consistent year over year. Your financial statements and tax return must be consistent and use the same method.
It’s best to choose—and stick to—an inventory valuation method. Changing your inventory accounting practices means filling out and submitting IRS Form 3115. Sticking to a method of inventory valuation is key in keeping tax-ready books.
If you want tax ready books to be a worry of the past, try Bench. We reconcile, review, and repeat until your finances are CPA ready so you don’t have to.
Alternatives to the LIFO method
There are three other valuation methods that small businesses typically use.
First In, First Out (FIFO)
The opposite to LIFO is FIFO, which is when you assume you sell the oldest inventory first. This is the preferred method for most retailers due to the way it reflects how their operations actually work.
Average cost inventory
The simplest valuation method is the average cost method as it assigns the same cost to each item. The average cost is found by dividing the total cost of inventory by the total count of inventory.
Specific inventory tracing
If you’re a business looking for the most amount of detail, specific inventory tracing has the insight you’ll need. But it requires tracking every cost that goes into each individual piece of inventory. This is best for businesses that move a low volume of high cost products.
How to track inventory
Maybe you’ve got a wide catalogue of products or maybe you just have one that you want to stay on top of. Whatever level of insight you need, there’s an inventory management solution that has you covered. A POS system for selling online like Shopify will typically track inventory for you. If you’re wanting to handle it all yourself, there are free templates available online. Once you’re needing a dedicated inventory system, Zoho Inventory is free to start.
Additional resources
For more bookkeeping basics:
- Working Capital: What It Is and How to Calculate It
- What Is Depreciation? and How Do You Calculate It?
- Liquidity: A Simple Guide for Businesses
- How to Read (and Analyze) Financial Statements
For more software solutions:
