Understanding LIFO Inventory Valuation
LIFO inventory valuation is based on the premise that older inventory is held in order to sell the most recent inventory purchased. Since inflation states that prices rise over time, the most recent inventory purchased is always at a higher cost than older inventory. What’s the benefit of selling more expensive inventory, you ask? Well, while the inventory is at a higher cost, and the gross profit per sale is lower, a company running LIFO is able to report lower income, and therefore has a lower tax burden. In essence, the company is trading higher gross profits for a lower overall tax rate. Companies using LIFO have a lower gross profit because of the higher value of the inventory sold on each transaction.
This is where LIFO’s outdated approach rears its ugly head. Since LIFO’s main purpose is to keep older inventory over extended periods, it leads to a number of damaging effects that eventually erode any of LIFO’s benefits. Before delving into the pitfalls of running LIFO, it’s perhaps best to provide an example of how LIFO works. As mentioned, LIFO means “last in first out." If a company purchased inventory over four quarters of their fiscal year, they would likely encounter rising costs on each subsequent purchase. We’ll assume the following inventory costs for each of these four quarters.
- Quarter 1: 500 units at a per unit cost of $2.00
- Quarter 2: 500 units at a per unit cost of $2.10
- Quarter 3: 500 units at a per unit cost of $2.15
- Quarter 4: 500 units at a per unit cost of $2.20
For LIFO to work, the company would hold its older inventory while ensuring it sells its most recent inventory purchased. In this case, the company would sell the inventory purchased in their second quarter ahead of inventory from their first quarter, the third ahead of its second, and its fourth ahead of any other quarter. This leads us to the following reasons why LIFO is an outdated and antiquated inventory valuation method.