The LIFO Method (Last In, First Out) is a valuation method that assumes the last goods purchased or produced are sold first. In theory, a business always sells its newest inventory items first, before selling older inventory.
In contrast, the opposite of the LIFO method would be the First In, First Out (FIFO) method.
Example of the LIFO Method
John sells bottled water to customers. He buys the water in cases of 25 bottles each. He buys one case on Monday, a second on Tuesday, and a third on Thursday. John has 75 bottles of water in his warehouse. If John sells five bottles to customers on Friday, it is assumed the bottles were pulled from the case purchased on Thursday, even though they very well could have come from the case purchased on Monday or Tuesday.
Impact of the LIFO Method?
Lower Inventory Valuation. Using the LIFO method generally results in a lower inventory valuation on the company balance sheet. Inventory value is lower because inflation usually raises the costs of all goods purchased. By selling the most recently purchased higher-cost inventory first, the older lower-cost inventory remains on the company’s balance sheet.
Lower Net income. LIFO also generates lower net income because the company’s cost of goods sold (COGS) is higher. By expensing the higher-cost inventory, the COGS expense at year-end will be higher than if using the FIFO method.
Lower Taxes. If the LIFO method results in lower net income, it will generally result in a smaller income tax bill. Lower profits mean less taxes.