INSIGHT

What is LIFO (Last In, First Out)?

April 23, 2025

When you’re running a business with inventory, the accounting method you pick doesn’t just sit in some dusty back office – it actively shapes your financial picture and how much you’ll fork over to the tax authorities.

For consumer business companies dealing with changing inventory costs, understanding LIFO (Last In, First Out) accounting is essential. This method assumes that your most recently purchased inventory items are sold first, creating important financial implications in an inflationary environment.

How LIFO works in consumer businesses

LIFO accounting operates on a simple principle: the latest inventory you purchase is the first to be recorded as sold. This contrasts with FIFO (First In, First Out), where older inventory is considered sold first.

For consumer businesses like retailers, electronics stores, or fashion brands, LIFO can be particularly relevant when:

Product costs are steadily increasing due to inflation
You maintain significant inventory levels
Tax efficiency is a priority for your business strategy
Your business operates primarily in the United States where LIFO is permitted

When product costs rise over time, LIFO allows you to match current higher costs against current revenues, providing a more accurate picture of your true replacement costs.

LIFO calculation example for retail businesses

Let’s look at how LIFO works in practice for a clothing retailer:

Fashion Forward purchases inventory throughout the fall season:

September 1: 100 jackets at $40 each
October 1: 150 jackets at $45 each
November 1: 200 jackets at $50 each

By December, the store sells 300 jackets. Using LIFO accounting, the cost of goods sold would be calculated as:

200 jackets at $50 = $10,000 (November inventory)
100 jackets at $45 = $4,500 (portion of October inventory)
Total COGS: $14,500

The remaining inventory value would be:

50 jackets at $45 = $2,250 (remaining October inventory)
100 jackets at $40 = $4,000 (September inventory)
Total remaining inventory value: $6,250

Tax advantages of LIFO for consumer companies

One of the primary reasons consumer businesses choose LIFO is its potential tax advantages. In periods of inflation, when inventory costs are rising, LIFO typically results in:

Higher cost of goods sold (COGS)
Lower gross profit
Reduced taxable income
Decreased tax liability

For seasonal businesses or those with significant inventory fluctuations, these tax savings can be substantial, freeing up cash flow that can be reinvested in your business operations, new product development, or expansion efforts.

Financial statement implications

While LIFO may offer tax advantages, it’s important to understand how it affects your financial statements. Using LIFO generally results in:

Lower reported profits on income statements
Lower inventory values on balance sheets

Potentially less favorable financial ratios for investor analysis

A growing gap between reported inventory value and current market value

If your business seeks external investment or loans, these financial statement effects require careful consideration, as they may influence how potential investors or lenders view your company’s financial health.

LIFO reserve – tracking the difference

When you adopt LIFO accounting, maintaining a LIFO reserve becomes essential. This account tracks the difference between your inventory valuation under LIFO versus what it would have been under FIFO.

The LIFO reserve represents the amount of income tax your business has deferred by using LIFO instead of FIFO. For consumer businesses experiencing consistent cost increases, this reserve can grow substantially over time, highlighting the cumulative tax benefit you’ve received.

Analysts and investors often examine the LIFO reserve to understand your “true” inventory value and to make your financial statements more comparable to companies using different inventory methods.

LIFO limitations for consumer businesses

Despite its advantages, LIFO isn’t suitable for every consumer business:

International restrictions: LIFO is not permitted under International Financial Reporting Standards (IFRS), only under U.S. GAAP
Inventory management challenges: Can lead to older inventory remaining unsold, which is particularly problematic for fashion retailers, food businesses, or technology companies where product obsolescence is a concern
Administrative complexity: Requires more detailed record-keeping and calculation than other methods
Financial statement comparability: Makes comparing your financial performance to companies using different inventory methods more difficult

Is LIFO right for your consumer business?

When considering LIFO for your business, assess these factors:

Is your business primarily U.S.-based with no international reporting requirements?
Are your inventory costs consistently rising?
Is tax efficiency a higher priority than maximizing reported profits?
Do your products have a long shelf life with minimal risk of obsolescence?
Can your accounting systems handle the additional complexity of LIFO calculations?

For many consumer businesses facing inflationary pressures, LIFO provides valuable tax deferral benefits that outweigh the potential drawbacks. However, this decision should be made in consultation with experienced accounting professionals who understand your specific business model and financial goals.

Get guidance on inventory accounting methods

Choosing the right inventory valuation method is a significant decision that impacts your tax liability, financial reporting, and business operations. At BPM, our consumer business accounting specialists can help you evaluate whether LIFO accounting aligns with your company’s strategic objectives.

Our team understands the unique inventory challenges facing retailers, manufacturers, distributors, and other consumer businesses. We’ll work with you to implement the most advantageous accounting methods while ensuring compliance with all applicable regulations.

Contact BPM today to discuss how we can optimize your inventory accounting approach and help your consumer business thrive in today’s competitive marketplace.