Last In, First Out (LIFO) is an inventory valuation method used in accounting. It operates on the assumption that the most recently acquired inventory items are the first ones to be sold or used. Think of it like a stack of plates: the last plate placed on top is the first one you'd take when you need one. This method primarily affects how the Cost of Goods Sold (COGS) and ending inventory are calculated.

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When using LIFO, every sale or usage occurs, and the cost assigned to that item is the cost of the latest similar item added to the inventory. The items that came in last are considered to be going out first, at least for costing purposes.

Let's say a storeroom receives a batch of identical spare parts:

• On April 3, 225 units are bought at $16 each. These are the newest items.
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• Before this, on March 16, a batch was bought at $12 each.
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If 250 units are then requisitioned for use:

• Under LIFO, the cost of the first 225 units used (from the April 3rd purchase) is $16 each.
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• To account for the remaining 25 units (250 total - 225), the cost is taken from the next most recent purchase – the March 16th batch at $12 each.
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So, the cost applied to the 250 units used would be based on these two most recent cost layers.

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Let's walk through a month of inventory transactions for a specific part using LIFO:
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May 1: Beginning inventory: 20 units at $30 each.
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May 3: Purchased 30 units at $35 each.

Inventory now consists of:

• 20 units @ $30
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• 30 units @ $35 (newest)

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May 5: Sold/Used 35 units.

Under LIFO, the cost of these 35 units is determined by looking at the last items:

• First, the 30 units purchased on May 3 @ $35 each are considered sold.
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• Then, the remaining 5 units needed (35 total - 30) are taken from the May 1st beginning inventory @ $30 each.
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• Cost of Goods Sold (COGS) for this transaction: (30×$35)+(5×$30)=$1,050+$150=$1,200.
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Remaining inventory: 15 units @ $30 each.
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May 11: Purchased 5 units at $45 each.

Inventory now:

• 15 units @ $30
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• 5 units @ $45 (newest)

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May 28: Purchased 10 units at $48 each.

Inventory now:‍

• 15 units @ $30
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• 5 units @ $45
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• 10 units @ $48 (newest)
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May 31: Sold/Used 25 units.

Using LIFO, the last 25 units purchased (in terms of cost layers) are considered sold first:

• The 10 units from May 28 @ $48 each.
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• The 5 units from May 11 @ $45 each.
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• The remaining 10 units (25 total - 10 - 5) from the oldest May 1st batch (which are now at the ""top"" of what's left of that layer) @ $30 each.
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COGS for this transaction: (10×$48)+(5×$45)+(10×$30)=$480+$225+$300=$1,005.

Remaining inventory: 5 units @ $30 each.

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Summary for May:

• Total Cost of Goods Sold for May: $1,200(from May 5)+$1,005(from May 31)=$2,205. This figure is reported on the income statement.
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• Ending Inventory Value at May 31: 5 units×$30=$150. This value is reported on the balance sheet.
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This example shows how LIFO assigns the cost of the most recent purchases to COGS first, impacting both the income statement and the inventory valuation on hand.

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The primary appeal of LIFO is its ability to match the most recent inventory costs against current revenues. This is particularly relevant during periods of rising prices (inflation). When costs go up, LIFO assigns higher, more current costs to the items being sold or used, which can provide a more realistic picture of the cost to replace those items.

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LIFO is often considered in specific situations:
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• Periods of Inflation: When prices consistently rise, LIFO results in higher COGS. This, in turn, can lead to lower reported profits and potentially lower tax liabilities (in jurisdictions where LIFO is permitted for tax purposes).
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• Industries with Stable Inventory: For businesses where inventory doesn't spoil or become obsolete quickly (e.g., certain raw materials, some spare parts), holding older cost layers in inventory for extended periods is less of a practical issue.
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• Matching Current Costs: When a business wants its income statement to reflect the current cost of replacing inventory sold, LIFO can achieve this better than methods like FIFO (First In, First Out).
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It's crucial to note that LIFO is not permitted under International Financial Reporting Standards (IFRS), which many countries outside the United States use. U.S. GAAP (Generally Accepted Accounting Principles) does allow LIFO, but there are specific rules and consistency requirements.

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• Better Matching in Inflation: It matches current revenues with the most recent (and often higher) costs, which can provide a more realistic reflection of profitability during inflationary periods.
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• Potential Tax Benefits: In times of rising prices, the higher COGS under LIFO can lead to lower taxable income, thus deferring income tax payments. This is a significant reason for its use where allowed.

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• Outdated Inventory Values: The ending inventory value on the balance sheet reflects older, potentially much lower costs. This can understate the true, current value of inventory assets.
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• LIFO Liquidation: If a company significantly reduces its inventory levels (sells more than it buys), it may have to "liquidate" old LIFO layers. This means matching very old, lower costs against current revenues, which can distort financial results by showing unusually high profits and potentially creating a larger tax burden in that period. For instance, inventory purchased decades ago might still be on the books, and its eventual sale can lead to an abnormally low COGS.
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• Lower Reported Profits: While potentially good for taxes, the lower profits reported under LIFO during inflationary times might not be viewed favorably by investors or lenders.
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• Complexity: LIFO can be more complex to administer than other inventory methods, requiring detailed record-keeping of different cost layers.
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• Reduced Comparability: Since LIFO isn't allowed under IFRS, it can make financial statement comparisons between companies using different accounting standards more difficult.
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• Physical Flow Mismatch: LIFO often doesn't reflect the actual physical flow of goods, especially for perishable items or products where the older stock should be used first.

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Last In, First Out (LIFO) is an inventory costing method that assumes the last items purchased are the first ones sold. Its main advantage lies in matching current costs with current revenues, particularly during inflationary times, which can offer tax benefits. However, it can also lead to outdated inventory values on the balance sheet and potential profit distortions if old inventory layers are liquidated.
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The choice to use LIFO is a significant accounting decision that depends on the specific industry, inflationary trends, regulatory environment (like its prohibition under IFRS), and a company's financial reporting strategy. For entities managing significant inventories, like MRO (Maintenance, Repair, and Operations) spare parts in industrial settings, understanding LIFO's LIFO's impact on costs and financial statements is crucial.