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Is LIFO Still Used by Today's Businesses?
When it comes to inventory valuation, most companies have a choice between average cost, FIFO (first in first out), and LIFO (last in first out). Among these choices, LIFO has become a less viable alternative for today’s businesses. LIFO’s outdated approach manifests itself in the basic principle that the most recent inventory purchased is the first inventory sold. Therefore, older inventory is retained. While there are some benefits, such as a lower tax rate, LIFO is an outdated and antiquated approach that erases any short-term gains with long-term consequences.
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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This is where LIFO’s outdated approach rears its ugly head.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.
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1. Inventory Damage & Obsolescence
Most companies ignore the impact of damage and obsolescence to their inventory. Unfortunately, when looking at a company’s total cost of inventory, these two items are often at the top of the list. Damaged and obsolete inventory is extremely costly. In most cases, this inventory is virtually impossible to sell. Most companies have little recourse but to liquidate this inventory for scrap or at a huge discounted rate. The longer that inventory is held, the more likely damage and obsolescence will occur.
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2. LIFO Ignores a Company’s Daily Cost of Money
There will always be one constant when it comes to inventory management. The longer inventory is held, the more expensive it becomes. One of the main drivers of this cost includes the daily cost of money. Since most companies use business credit to finance the purchase of inventory, every day that inventory is held and not sold is just another cost of financing that inventory. The interest rates on business credit simply pile up over time.
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3. Eventual Inventory Liquidation Raises Income & Taxes
LIFO’s outdated approach is perhaps most obvious when companies are finally forced to liquidate all their older inventory. Some companies running LIFO retain old inventory for extremely long periods and, in most cases, are then forced to liquidate that inventory. Once that happens, it immediately inflates a company’s net income and results in a higher tax rate. Eventually, the company ends up paying higher taxes once it finally decides to liquidate its older inventory. In essence, this defeats any perceived benefit of running LIFO.
When it comes to discussing LIFO’s outdated approach, one must always be cognizant of these aforementioned three points. While LIFO does allow companies to benefit from a lower tax rate, the overall benefits are negligible once the company accounts for the higher risk of inventory damage and obsolescence, the impact of the daily cost of money, and the eventual higher taxes that result once the company finally liquidates its older inventory. Choosing an inventory valuation method is never easy. However, given the inherent limitations of LIFO, both FIFO and average cost have become far more relevant in today's business climate.