The Pros Vs. Cons for the "Last in, First Out" Inventory Method (2024)

The "Last In, First Out" inventory method has been hotly debated at the federal level. Congress has threatened to outlaw the method as the Internal Revenue Service introduces laws and requirements that make using the LIFO method inconvenient at best. Using the LIFO method of inventory means that when you count the cost of goods sold, you use the current price rather than whatever price you paid for the specific inventory in stock. If the prices of those goods go up from your initial purchase, your cost of goods sold will read higher, thereby reducing your profits and, as a result, your tax burden and access to credit. If the costs go down, your profits may be artificially inflated.

Taxes

The primary reason that companies choose to use an LIFO inventory method is that when you account for your inventory using the "last in, first out" method, you report lower profits than if you adopted a "first in, first out" method of inventory, known commonly as FIFO. The lower the profits you report, the less taxes you have to pay. To give you an idea of the magnitude of these savings, George Plesko, an accounting professor at the University of Connecticut, calculates that the government lost out on $18 billion in tax revenue from 1975 to 2004, before tax credits, thanks to LIFO.

Profits

Reported profits are lower in an LIFO environment because of the change in cost of goods sold. To illustrate the concept of LIFO and its relation to reported profits, imagine that you purchase a widget for $10 that you later sell for $15. In six months, the price goes up to $12. When you write off the cost of goods sold, you would use the most recent price, or $12, under the LIFO inventory method. As such, it would appear that you had only made a $3 profit.

Had you used a "first in, first out" inventory method, you would have used the price you paid for the actual good sold, or $10, so you would report a profit of $5. By using LIFO, your profit would appear to be reduced by $2, from $5 to $3, which would effectively reduce the amount of taxes you have to pay.

Changes in the Economy

Of course, the benefit of using the "last in" pricing for the cost of goods sold is dependent upon how the price of an item fluctuates. For instance, companies that hold inventory for long periods, such as sheet metal fabricators, may find that holding inventory for several years to be advantageous and use as a way to hedge their profits for tax purposes. But prices could always go down. That widget that costs $10 today could cost $6 tomorrow, especially if the economy takes a sharp downturn like that seen in the dot-com bubble burst or the more recent housing bubble burst.

Reduced Earning

Further, when you use LIFO, you typically end up with depressed earnings. This may be a good thing when it comes to paying your taxes but it can cast a wary shadow over your company when you present your financial statements, as you would have to to investors, creditors, banks and suppliers. In this way, showing depressed earnings could hurt your chances of achieving funding or establishing a line of credit.

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