Last-In, First-Out (LIFO) inventory deductions allow companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. LIFO limits the impacts of volatile prices or inflation and lowers the tax cost of new inventory.
How Does Last-In, First-Out (LIFO) Work?
Under current law, businesses generally cannot deduct the cost of capital investments when they purchase them. Similarly, businesses cannot deduct the cost of inventories when they first produce or purchase them. Instead, businesses must deduct the cost of inventories when they are sold. Sometimes, however, different units of inventory cost different amounts than when they were produced or purchased, so the correct value of the deduction is not immediately obvious.
Businesses are generally allowed to choose among three methods when calculating their cost in a given year: First-in, First-out (FIFO); Last-in, First-out (LIFO); and Weighted-Average Cost.
In general, prices in the economy rise over time. By reducing the time between when a unit of inventory is acquired and when its costs are deducted, LIFO prevents inflation from reducing the real value of the deductions for the costs of goods sold.
A business normally maintains or increases its level of inventory, continuously replacing inventory as it is sold. If it uses LIFO, it continues to deduct the cost of the last inventory purchased, and it appears to never sell the earliest inventory purchased (at least on paper). Economically speaking, LIFO comes closest to deducting the full real value of inventory acquisition.
According to the Tax Foundation’s General Equilibrium Model, the elimination of Last-in, First-out accounting for write-offs of future inventory would raise the cost of capital and reduce economic growth, for a relatively small increase in revenue.
Unless a special provision were made, LIFO repeal would also retroactively tax a company’s “LIFO reserve.” This additional tax could hit cash-strapped companies particularly hard and could result in tens of thousands of additional job losses in the short run.
An Example of Last-In, First-Out (LIFO)
Suppose a business purchases three units of inventory throughout the year at three different prices ($30, $31, and $32). The company sells one unit of its inventory at $40.
Under LIFO, a business assumes that the last inventory purchased is the first to be sold. In this case, the business is assumed to have sold the last unit purchased for $32, so the amount the business can deduct against taxable income is $32. This results in $8 of additional taxable income.
When the business sells the next unit of inventory, it would then deduct the cost of the second unit for $31; and on the third sale, it would deduct the first unit purchased for $30.
Stay updated on the latest educational resources.
Level-up your tax knowledge with free educational resources—primers, glossary terms, videos, and more—delivered monthly.
Subscribe
FAQs
Last-In, First-Out (LIFO) inventory deductions allow companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. LIFO limits the impacts of volatile prices or inflation and lowers the tax cost of new inventory.
What is LIFO last in, first out queue? ›
LIFO stands for 'last in, first out' and uses a stack data structure. In a LIFO data structure, the newest element added to the stack is processed first. On the other hand, FIFO stands for 'first in, first out' and uses a queue data structure.
What is an example of last in, first out LIFO? ›
Example of LIFO
Assume company A has 10 widgets. The first five widgets cost $100 each and arrived two days ago. The last five widgets cost $200 each and arrived one day ago. Based on the LIFO method of inventory management, the last widgets in are the first ones to be sold.
What refers to last in, first out LIFO data structure? ›
LIFO refers to Last In First Out. It means that when we put data in a Stack, it processes the last entry first. Conversely, FIFO refers to First In First Out. It means that when we put data in Queue, it processes the first entry first.
Is last in, first out LIFO first in, first out FIFO or a market value accounting approach? ›
The Last-In, First-Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first. The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.
What is LIFO with example? ›
The last in, first out, or LIFO (pronounced LIE-foe), accounting method assumes that sellable assets, such as inventory, raw materials, or components, acquired most recently were sold first. The last to be bought is assumed to be the first to be sold using this accounting method.
How to solve LIFO method? ›
Let's say you've sold 15 items, and you have 10 new items in stock and 10 older items. You would multiply the first 10 by the cost of your newest goods, and the remaining 5 by the cost of your older items to calculate your Cost of Goods Sold using LIFO.
What is the last in, first out order? ›
Last in, first out (LIFO) is a method used to account for how inventory has been sold that records the most recently produced items as sold first.
What is the FIFO LIFO method? ›
The first in, first out (FIFO) cost method assumes that the oldest inventory items are sold first, while the last in, first out method (LIFO) states that the newest items are sold first. The inventory valuation method that you choose affects cost of goods sold, sales, and profits.
What is LIFO terms? ›
Last In / First Out: an accounting method used in managing a company's inventory. LIFO assumes that the products bought or most recently manufactured are sold first.
Two Common Approaches
- FIFO. This method assumes that your business sells its inventory in the order that it was purchased. ...
- LIFO. This method assumes you sell your most recently purchased items first.
LIFO stands for “Last In, First Out“. This principle dictates that the last element added to the stack is the first one to be removed. In other words, the most recently added element is always at the top, and any operations on the stack will affect this top element.
What is the last in, first out problem? ›
Last in, First Out (LIFO) is an inventory costing method that assumes the costs of the most recent purchases are the costs of the first item sold. The LIFO method, which applies valuation to a firm's inventory, involves charging the materials used in a job or process at the price of the last units purchased.
What is the order of the LIFO stack? ›
A stack follows a last-in-first-out (LIFO) ordering: the most recently added item is the first one to be removed. A queue, on the other hand, follows a First-In-First-Out (FIFO) ordering: the item that has been in the queue the longest is the first to be removed.
What is FIFO and LIFO in queuing theory? ›
Queuing Discipline represents the way the queue is organised (rules of inserting and removing customers to/from the queue). There are these ways: 1) FIFO (First In First Out) also called FCFS (First Come First Serve) - orderly queue. 2) LIFO (Last In First Out) also called LCFS (Last Come First Serve) - stack.
What is the LIFO FIFO rule? ›
LIFO is an accounting method in which assets purchased or acquired last are disposed of first. In an inflationary market, lower, older costs are assigned to the cost of goods sold under the FIFO method, which results in a higher net income than if LIFO were used.
Why choose LIFO over FIFO? ›
During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO, firms can save on taxes as well as better match their revenue to their latest costs when prices are rising.
