Last In First Out Method (LIFO)

Definition

The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation.  The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.

Explanation

Also referred to as LIFO, the last-in, first-out method assumes the newest items held in stock are the first items to be sold.  This is an assumption used to value the company's inventory; the physical flow of items from inventory may differ from this valuation technique.

While this approach might seem counter-intuitive, there are strong arguments that support the LIFO method.  Proponents of LIFO believe that income values should be based on current market costs.  That is to say, current revenues should be aligned with current costs.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet.  It's also important to understand the ending inventory value for one year is the beginning inventory value in the following year.  Inventory errors likewise have an effect on net income.  For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

The following table illustrates the LIFO approach to valuing inventory.  Company A begins the year with 250 units, adds 400 units throughout the year, and sells 500 units.  The ending inventory for Company A is 150 units.

  Units Cost per Unit Total Cost
Beginning Inventory 250 $700 $175,000
Additions on March 1 100 $725 $72,500
Additions on June 1 100 $750 $75,000
Additions on September 1 100 $775 $77,500
Additions on December 1 100 $800 $80,000
Goods Available for Sale 650   $480,000
Units Sold 500    
       
Units from Beginning Inventory 150 $700 $105,000
       
Ending Inventory 150   $105,000

The above ending inventory of $105,000 can be used along with the cost of goods available for sale ($480,000) to determine the Cost of Goods Sold:

= Cost of Goods Available for Sale - Ending Inventory
= $480,000 - $105,000, or $375,000

Related Terms

inventory, first in, first out, average cost method, balance sheet, asset, gross profit method, lower of cost or market, retail method