What is LIFO?
LIFO stands for “Last In, First Out”. LIFO is an inventory management method that the last items received or produced are the first items that are prioritized to be sold or used.
An example of LIFO in use is in a manufacturing company’s inventory management. Let’s say a manufacturing company produces and stores a certain type of a component, for example, a specific type of a gear.
The company produces 200 gears on Monday and another 100 gears on Wednesday.
Under the LIFO method, the company would use the gears produced on Wednesday first, as they were the last ones produced. The company would use the first 100 gears produced on Wednesday, and then move on to the gears produced on Monday to use the remaining 200 gears.
This way, the company is ensuring that it is using the most recent items first, which can help minimize the risk of having to use outdated or obsolete items.
Tax benefits: LIFO can also result in tax savings because it can result in lower reported income and thus lower taxes. This is because LIFO allows companies to use the cost of the most recent items when calculating the cost of goods sold.
Reflects real-world situations: In some cases, the last items received or produced are also the first items to be sold or used, as the most recent items added to inventory are assumed to have the highest cost.
Can help to improve customer satisfaction: By ensuring that the items being sold or used are the most recent and up-to-date, LIFO can help to improve customer satisfaction.
Sometimes it results in higher carrying costs: If older items are not sold or used quickly enough, the cost of storing them for an extended period of time can become significant.
Obsolete inventory: It can lead to obsolete inventory, as older items may be left in stock for long periods of time.
Can lead to stockouts: If items are being sold or used quickly, there is a risk that the inventory will run out before new items can be received or produced.
May not be the best option for certain types of inventory: LIFO may not be the best option for certain types of inventory, such as perishable goods, that have a shelf life.
Compliance: In some countries, LIFO is not allowed for tax compliance (Not accepted by Generally Accepted Accounting Principles (GAAP) for financial statements). LIFO also not an allowed method of inventory valuation for companies that trade internationally.