New
December 30, 2022
By
Reddy Mohith

Last In First Out (LIFO): Overview and Differences

Focus Keyword: Last In First Out, LIFO

Every business aims to bag profits by paying less in taxes at the end of the day. While firms use tens and hundreds of strategies to make profits, LIFO is another way most businesses opt. So, what is last in first out (LIFO), and how does this method help businesses? Read further to know why enterprises prefer LIFO to gain positive returns.

Overview of LIFO (Last In, First Out)

The LIFO stands for Last In, First Out. As the term represents, it states that the firms sell the most lately purchased inventory first.

For instance, let us say that you bought 5 mobile phones a couple of months ago for 12,000 INR each. A few days ago, you purchased another 5 mobile phones of the same model worth 15,000 INR each. With the LIFO method, you sell customers 15,000 INR worth of phones before by keeping the less expensive goods in your inventory. The LIFO process helps in saving money on taxes.

Then, when you calculate the total inventory value for tax, LIFO enables you to estimate the value of the remaining less-expensive inventory (12,000 INR phones), so you pay less in taxes. One of the advantages of using this accounting method is that the sales cost will almost match the current value of inventory, and the drawback of this method is that it values the merchandise at old cost levels.

Difference between LIFO and FIFO

Because each technique bases its assumptions on separate sold units, FIFO and LIFO product valuations are not the same. One must picture inventory items on a shelf, each with a cost associated with it, to comprehend the differences between FIFO and LIFO inventory flow.

The term "inflation" refers to the general increase in costs over time, and it is assumed in this discussion that older inventory items were purchased at a lower price than more recent ones. Prices rise from one year to the next because the economy experiences some inflation most years.

Finally, timing is the reason why FIFO and LIFO expenses differ. The overall cost of the products sold is the same when all stock items get sold, irrespective of the pricing model you use for a specific accounting period.

The following are the fundamental distinctions between FIFO and LIFO:

Utilizing FIFO to value inventories

According to FIFO, older inventory products are cheaper than more recent acquisitions because it is assumed that they would be the first ones sold. Using FIFO produces the following outcomes:

Sold Goods Cost: Hawking the older, less expensive units first result in a lower cost per unit than LIFO.

Ending inventory: Its balance is higher than the LIFO approach and contains the latest, more expensive units.

Net income (profit): The FIFO approach yields a higher profit than LIFO due to the reduced cost of products sold balance.

The economic effect varies when you sell new, more expensive things before selling inexpensive products.

LIFO-based inventory valuation

LIFO assumes that the recently bought most expensive items purchased would be sold first. The financial outcomes of utilizing LIFO are:

Cost of goods sold: FIFO results in a lower price for the products sold than offering the more expensive items first.

Ending Inventory: Ending inventory has a smaller equilibrium than the FIFO technique and contains the earlier, less expensive units.

Net income (profit): The LIFO approach yields a lower profit than FIFO due to the higher cost of products sold balance.

In conclusion, the balance sheet often shows a lower net profit and elevated sold product costs when employing the LIFO method.

LIFO, Inflation, and Net Income

All three inventory commanding approaches produce the same result during the no-inflation period. However, the accounting methods that businesses select can influence the valuation proportions when inflation is high. LIFO, FIFO, and average cost have multiple impacts. They are:

LIFO:

Due to the possibility of understating inventory value, LIFO is not a reliable indicator of finishing inventory value. Due to increasing COGS, LIFO leads to reduced net income (and taxes). However, under LIFO during inflation, there are fewer inventory write-downs.

FIFO:

Although FIFO boosts net income since COGS are valued using inventory that may be several years old, it also gives a better representation of the value of closing merchandise(on the income statement). Increased net income may sound fantastic, but it can also result in more taxes due from the business.

And results from the average cost are in the middle of FIFO and LIFO. If prices decrease, the exact reverse of what was stated above will be factual.

Suggestions

Read more: Difference between Small Business Vs Startup, Business Ideas | Swipe Billing App, My Business Story: Anjana Mobiles

Related Blog Post