How the LIFO Inventory Method Benefits Businesses in Adverse Markets

Businesses are not very optimistic about rising inventory prices, according to recent survey data on business supply chains. Luckily, in times of rising costs, businesses can leverage certain accounting strategies to protect profitability. Among available inventory costing techniques, the Last In, First Out (LIFO) method offers distinct advantages for businesses battling inflating expenses. Learn more about the LIFO inventory method, its benefits and how to use it to master your inventory management.

The LIFO Inventory Method: A Brief Overview

The LIFO inventory method is an accounting approach where the most recently acquired items in inventory are assumed to be sold first. Unlike traditional methods that might align more closely with the actual flow of goods, LIFO targets the cost of goods, attributing the latest inventory costs to the cost of goods sold (COGS). 

That means that your company’s revenue, as of today, is matched with the most recent—and often the more expensive—inventory costs, which increases your cost of goods sold (COGS) and gives you a more realistic idea of your profit margins in an adverse market.  

Why the LIFO Inventory Method Can Help With Profitability

If the LIFO inventory method paints a more negative picture of your profit margins, how can it be beneficial? In an ever-fluctuating market, the LIFO method offers a few key benefits: 

• Taxation: In times of inflation, it can lead to a higher cost of goods sold and, consequently, a lower taxable income.
• Cash flow: By reducing taxable income, LIFO allows businesses to retain more cash. This is particularly helpful in inflationary markets, as it provides companies with additional capital that can be used for investment, debt or other everyday operational needs.
• Strategy: By aligning COGS with the most recent purchase prices, LIFO provides a more accurate reflection of current market conditions, helping businesses adjust their pricing strategies and manage profitability more effectively. 

How to Calculate Cost of Goods Sold Using LIFO 

The calculation of COGS under the LIFO method assumes that the last items added to the inventory are the first to be sold. To compute COGS using LIFO, follow these steps:

1. Determine the costs of the most recent inventory purchases during the accounting period.
2. Determine the number of units sold in the accounting period.
3. Attribute the cost of the most recently purchased items to the sold units, working backward until you account for all sold units.
4. Sum up the costs assigned to the sold units to arrive at the COGS for the period.

Example: LIFO Calculation

Imagine a company that sells laptops. Over a quarter, it made the following purchases:

• Beginning inventory: 10 laptops at $500 each in January.
• First purchase: 20 laptops at $520 each in February.
• Second purchase: 15 laptops at $530 each in March.

During the quarter, the company sold 30 laptops. Using the LIFO method, let’s calculate COGS:

1. Start with the most recent purchase. The last purchase was 15 laptops @ $530 in March. For the first 15 laptops sold, use the March purchase price: 15 laptops * $530 = $7,950.
2. Move to the next most recent purchase. After accounting for the 15 laptops sold from the March purchase, there are 15 laptops left to account for in the sales. The next most recent purchase before March was in February, with 20 laptops at $520.
3. Calculate total COGS. Add the costs from the March and February purchases to get the total COGS for the 30 laptops sold. Total COGS = $7,950 (March) + $7,800 (February) = $15,750.
4. Use the February purchase price for the next 15 laptops sold: 15 laptops x $520 = $7,800.

Using the LIFO method, the COGS for the 30 laptops sold in the quarter is calculated to be $15,750. This calculation assumes that the laptops sold first came from the most recent purchases, and the total cost is higher than if the company had used the First In, First Out method. 

LIFO vs. FIFO: Understanding the Differences

While LIFO focuses on the last-in costs for COGS calculation, the first in, first out (FIFO) method assumes that the first items added to the inventory are the first to be sold. This fundamental difference leads to distinct outcomes, especially in times of price changes:

• Impact on COGS: LIFO typically results in higher COGS during inflation, whereas FIFO might show lower COGS, reflecting older, possibly lower costs.
• Tax implications: LIFO can lead to lower taxable income in inflationary periods, unlike FIFO, which might show higher profits and thus higher taxes.
• Inventory valuation: FIFO tends to result in a higher ending inventory value on the balance sheet, which contributes to higher total asset valuations, greater borrowing capacity and improved margins.

6 Steps for Implementing LIFO

Implementing the LIFO inventory method involves several key steps:

1. Evaluate suitability: Assess whether LIFO aligns with your business model, inventory types and financial goals. Consider the nature of your inventory and whether its costs are subject to inflation. You may need to wait for the next accounting period or year to make this change, which can require IRS approval and updates to previous financial reports.
2. Consult with experts: Engage fractional finance or accounting experts to understand the implications of LIFO on your financial statements, tax obligations and compliance requirements.
3. Update inventory systems: Modify your inventory management systems to track inventory acquisition dates and costs accurately, ensuring that the most recent purchases are appropriately allocated to COGS.
4. Implement internal controls: Establish robust internal controls to manage and monitor inventory effectively under the LIFO method, ensuring accuracy and compliance with accounting standards.
5. Educate your team: Train your accounting and finance teams on LIFO principles, calculations and reporting requirements to ensure a smooth transition and ongoing adherence to the method.
6. Review and adjust regularly: Periodically review the impact of LIFO on your financial statements and tax position, adjusting your strategy as needed to align with changing market conditions and business objectives.

By carefully following these steps and leveraging expert guidance, businesses can successfully implement the LIFO inventory method, optimizing their financial management and gaining strategic advantages in the marketplace.

How Fractional Experts Can Help with LIFO Inventory Accounting

Sometimes your business needs some extra help to find the strategies that work best for you. 

• Assessment: Fractional finance experts can guide business owners through the strategic implications of choosing LIFO over other inventory methods, ensuring alignment with the company’s financial goals.
• Tax planning: They can help navigate the tax advantages of LIFO, providing advice on managing taxable income and optimizing cash flow.
• Implementation: They ensure that LIFO accounting is correctly implemented and reported.
• Strategic action: By analyzing COGS and its impact on gross profit, experts offer insights into pricing strategies, cost control measures and overall business performance.

Start Using LIFO in Your Business

Adopting the LIFO method requires careful consideration of your business model, inventory turnover and market conditions. Consult with a fractional finance or accounting expert to gain a deeper understanding of how LIFO can impact your profitability and weather difficult market changes. Paro’s outsourced accounting solutions, including controller leadership, can help you implement the right inventory method moving forward. Match with a vetted expert in as little as 48 hours.