‘First come, first served’ and ‘use the oldest milk in the fridge first before it goes off, dear’ among other phrases and situations all have a common denominator and present the same logic; we always seem to use the oldest of something in life first and the newest, the freshest, is kept for last. This simply makes sense. Well, in accounting, there is a concept or assumption that turns this all on its head. This is the LIFO concept. But what on earth is it?
What is LIFO?
LIFO inventory is the acronym for ‘Last-In-First-Out’ and is an accounting practice that dictates what value is given to certain items in inventory. It is important to allocate value systematically to inventory sold, which allows one to ascertain the cost of goods sold. This then dictates how much profit is left over and how much tax is required to be paid.
At the end of the day, the amount of tax paid on income is the driver for adopting a LIFO accounting system as the result, is less tax to pay. Even if this sounds fantastic in theory, thorough research must be done because it is outlawed by many countries for its potential to facilitate tax evasion.
How does LIFO work?
LIFO dictates that when it comes time to value the sold product, it is assigned the value of the latest products receipted into inventory, leaving the remaining inventory to be given the value of the oldest products. Now, it is important to remember that this is largely an assumption and does not necessarily relate to the actual goods sold being the most recent goods receipted into inventory.
The inventory valuation equation is as follows:
Beginning Inventory + Purchases – COGS = final inventory
Using this equation, we can see that if the sold products are assigned a greater value, because they were the last goods to be receipted into stock (as per the LIFO concept and operating under the assumption that there is inflation), then the final inventory value and profit will be less.
Now, this does not necessarily mean the actual cash-in-hand profit is less, but rather on paper, that is how it seems. It is important to be aware that there are positives and negatives for each method, though. With the LIFO method, there will be less tax to pay (as it is income-weighted). However, the trade-off from this is that the profits are less on paper, which is what potential investors will look at and therefore could result in some frustration or difficulty in securing investors’ financial support.
Should I use LIFO?
Only adopt LIFO if you have done extensive research into it and are confident it abides by the tax laws of the land. If it is not a feasible option, have a look at FIFO which, although reports a lower profit, it maximises the shelf life of the product, which further maximises profits through higher value of the goods sold.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.