When it comes to inventory management, there’s more to an optimized strategy than simply determining how inventory will be tracked. In fact, businesses also need to select an accounting method to track the cost of goods sold (COGS) for their inventory.
In this article, we will focus on one inventory accounting method: the last-in, first-out (LIFO) method.
What does LIFO stand for?
LIFO stands for last-in, first-out. It’s a method of inventory accounting that many businesses use to manage their inventory finances. LIFO assumes, when calculating cost of goods sold (COGS), that the inventory your business has acquired most recently is the first to be sold.
Related: Key inventory formulas and ratios
How does LIFO work for businesses?
Since the LIFO inventory accounting method assumes that the most recently acquired goods are the first to be sold, your accounting department will make calculations using the most recent purchase price until the number of items sold exceeds the number of items acquired at that newest cost.
Here’s an example to break it down:
Say you run a business that sells screwdrivers. You acquire them wholesale at the following rates during these months:
- April: 1,000 screwdrivers at $2.00 each
- March: 1,000 screwdrivers at $1.90 each
- February: 1,000 screwdrivers at $1.80 each
If you’re using the LIFO method, your accounting team will calculate profits using the April screwdriver cost first. So, if your business sells 1,500 screwdrivers, the first 1,000 screwdrivers sold would be calculated at the most recent rate of $2.00 each. The next 500 would be accounted for at the March rate of $1.90 each.
That means when it’s time to calculate your cost of goods sold, or COGS, the calculation would look like this:
COGS (Cost of Goods Sold) = [1000 × $2.0 (APRIL)] + [500 × $1.90 (MARCH)]
The cost of the remaining 500 screwdrivers from March and all 1,000 purchased in February are not utilized in the LIFO accounting method. And, if more screwdrivers are purchased before any of that remaining inventory is sold, those 1,500 March and February screwdrivers would not be used to calculate the cost of goods sold. Instead, the newest price of the newest screwdrivers acquired would be used.
Why Use LIFO?
The primary reason businesses prefer the last-in, first-out method is that it offers a significant tax advantage, especially during inflationary periods when the cost of goods sold is rising rapidly.
This is chiefly because the LIFO method directly increases the cost of goods sold when wholesale costs are rising. When a business has a higher cost of goods sold, it reduces its taxable income. And when taxable income is lower, a company typically owes less in taxes.
Keep in mind that LIFO is an accounting method, not an actual stocking and selling strategy.
Going back to the screwdriver example, your business doesn’t actually have to sell the screwdrivers it acquired in April first. It can sell the inventory that makes the most sense, for any number of reasons. LIFO is purely an accounting method, and it can differ significantly from how your business chooses to move and sell inventory in practice.
Before implementing the LIFO inventory accounting method, do your due diligence to ensure it’s an accepted form of accounting where you do business. While it’s generally accepted in the United States, many international businesses face restrictions on using the LIFO method.
FIFO vs. LIFO accounting: What’s the difference?
Unlike the last-in, first-out inventory method, the first-in, first-out (FIFO) method assumes that the oldest items are sold first. The FIFO method increases net income, lowers the cost of goods sold, increases ending inventory value, and may also increase a business’s tax liability.
Why, then, would any business want to use FIFO instead of LIFO? One reason is that FIFO is often beneficial for generating financial statements. It can be necessary for businesses that wish to demonstrate good cash flow, responsible spending, profit growth, and other signs of financial health.
It’s also much more common than LIFO. LIFO is primarily used by companies that maintain large and expensive inventories when inflation is increasing costs rapidly, and FIFO is used by most other businesses.
This easy, comprehensive guide will help you:
Free Ebook: Getting Started With Inventory Tracking
Tracking inventory costs
If you’re interested in using the LIFO accounting method (or FIFO, too), using inventory management software to track inventory costs can make the process that much simpler. Sortly inventory software automatically tracks virtually every detail of your inventory, including purchase and sale prices, even if your business stocks tens of thousands of items.
Additionally, if you’re using a solution such as Sortly, you can also export customized reports at any time to analyze the changing price of inventory over time.
Plus, barcode and QR code scanning features make perpetual inventory management that much easier. Every time an item is purchased or sold, inventory records can be updated at once. That means that all accounting calculations—including those used to determine cost of goods sold—can be conducted with confidence.
About Sortly
Sortly is an inventory management solution that helps you track, manage, and organize your inventory from any device, in any location. We’re an easy-to-use inventory software that’s perfect for large or small companies. Sortly builds inventory tracking seamlessly into your workday so you can save time and money, satisfy your customers, and help your projects succeed.
With Sortly, you can track inventory, supplies, parts, tools, assets, and anything else that matters to your business, including costs of goods sold. Sortly also comes equipped with smart features like barcoding & QR coding, low stock alerts, customizable folders, data-rich reporting, and much more. Best of all, you can update inventory right from your smartphone, whether you’re on the job, in the warehouse, or on the go.
Whether you’re just getting started with inventory management or you’re an expert looking for a more efficient solution, we can transform how your company manages inventory—so you can focus on your next build. That’s why over 15,000 businesses globally trust us as their inventory management solution.
Start your two-week free trial of Sortly today.
