Last-In, First-Out (LIFO)
What it is:
How it works/Example:
Let's assume you own the XYZ grocery store and you've decided to start selling cookies. You purchased a case of cookies last week for $25 and a case of cookies this week for $30. Which cookies do you sell first? Under the LIFO method, you would assume you sell the freshest cookies first (regardless of which cookie actually gets sold first).
To see the accounting effects, let's further assume you sell one case of cookies a month. Under the LIFO method, your cost of goods sold for the month would be:
Gross Cookie Sales: $100
Cost of Goods Sold: $30
Gross Margin: $70
Now consider the store's gross profit margin if you sold the older case of cookies first (that is, you used the first-in-first-out, or FIFO, method):
Gross Cookie Sales $100
Cost of Goods Sold: $25
Gross Margin $75
Inventory methods exist to deal with the fact that prices of commodities, raw materials, labor, and other inputs tend to change. When prices are rising, LIFO tends to deflate net income because new, more expensive inventory is used in the cost of goods sold calculation (this is not always bad; lower net income means a lower tax bill). When prices are falling, LIFO tends to overestimate net income because newer, less expensive inventory is used in the cost of goods sold calculation (and also results in a higher tax bill).
Why it matters:
As you can see, a company's choice of inventory method has a significant impact on how profitable it appears, especially if a large portion of its assets are tied up in inventory. The choice of inventory method also affects the amount of assets reported on a company's balance sheet and in turn affects many key debt, working capital, turnover, and other ratios. For this reason, it is important for investors to know what inventory method a company uses so they can effectively compare companies.