What Is LIFO? A Beginner-Friendly Explanation of Last-In, First-Out

What is LIFO?

LIFO stands for Last-In, First-Out. It's an inventory valuation method used in accounting that assumes the last goods purchased or produced are the first ones sold or used. LIFO affects how a business calculates cost of goods sold (COGS), ending inventory value, gross profit, and taxable income. It is a paper accounting convention and does not necessarily reflect the physical movement of goods.

Basic mechanics

Under LIFO, when you sell goods, the accounting system assigns the cost of the most recently acquired inventory items to COGS. Older inventory costs remain on the balance sheet as ending inventory. To maintain accurate records, LIFO often uses a layer system: each time you add inventory at a new price, you create a new LIFO layer. When you sell, you consume from the newest layers first.

Example

Imagine a company buys 100 units at $10, then 100 units at $12. If it sells 120 units, under LIFO COGS would be 100 x $12 + 20 x $10 = $1,240. The remaining inventory would be 80 x $10 = $800. Under FIFO (for comparison), COGS would have been 100 x $10 + 20 x $12 = $1,240 — in this simplified example results can match, but in periods of rising prices LIFO typically yields higher COGS and lower ending inventory than FIFO.

Accounting and tax implications

Key financial effects of LIFO in an inflationary environment include higher COGS (because recent, higher costs are matched to revenue) and lower gross profit and taxable income. That can produce tax deferral benefits for companies operating where LIFO is permitted. However, the balance sheet may undervalue inventory compared with current replacement cost. Companies using LIFO typically disclose a LIFO reserve — the difference between LIFO and FIFO inventory valuations — so financial statement users can compare results.

Where LIFO applies

LIFO is an accepted method under U.S. GAAP and U.S. tax law, but it is prohibited under IFRS. Therefore, companies reporting under IFRS cannot use LIFO. LIFO is often applied at the tax and financial reporting level inside ERP systems and accounting processes; physical operations in warehouses often follow FIFO for quality and rotation reasons.

Advantages

• Tax benefits during inflation: Higher COGS reduces taxable income, deferring taxes.
• Matching principle: Recent costs are matched with current revenues, reflecting current cost conditions in gross margin calculations.
• Cash flow: Tax deferral can improve short-term cash flow.

Drawbacks

• Inventory undervaluation: Ending inventory on the balance sheet can be understated compared with replacement cost.
• Comparability: Financial statements may be harder to compare with competitors using FIFO.
• Complexity: LIFO layers, reserves, and disclosures add accounting complexity and systems overhead.
• LIFO liquidation risk: Selling older inventory layers can produce unexpected income spikes and tax consequences if layers are consumed.

Practical considerations

When implementing LIFO, businesses must maintain accurate layer records and calculate the LIFO reserve. Software configuration in ERP systems is important because manual tracking is error-prone. Companies also must communicate the method's effects to stakeholders: lenders, investors, and tax authorities. Because LIFO can make margins look lower during inflation, management should explain underlying economics to avoid stakeholder confusion.

Physical flow vs. accounting flow

It’s important to distinguish physical handling from accounting valuation. A warehouse may physically pull the oldest goods first (FIFO) to preserve product quality while the accounting system still applies LIFO costing. That means physical operations and accounting can follow different rules — a normal situation — but it requires tight reconciliation so book values reflect the chosen costing policy.

Common beginner mistakes

1. Assuming LIFO is a physical handling rule — it is an accounting method.
2. Failing to track LIFO layers accurately in software.
3. Not disclosing or understanding the LIFO reserve and its effects on comparability.
4. Overlooking jurisdictional constraints (e.g., IFRS prohibits LIFO).

Bottom line

LIFO is a powerful inventory costing method for certain situations, especially in inflationary environments where businesses want to match recent costs to revenue and defer taxes. It comes with trade-offs: complexity, potential understatement of inventory values, and limited acceptability internationally. For beginners, the key is to understand LIFO as an accounting approach, not a mandate on how you physically move inventory, and to involve accounting, tax, and systems teams before adopting it.