What is LIFO?

LIFO is the acronym for last-in, first-out. It is a cost flow assumption that can be used by U.S. companies in moving the costs of products from inventory to the cost of goods sold.

Under LIFO the latest or more recent costs of products purchased (or produced) are the first costs expensed as the cost of goods sold. This means that the costs of the oldest products will be reported as inventory.

It is important to understand that while LIFO is matching the latest or most recent costs with sales on the income statement, the company can be shipping the oldest physical units of product. In other words, the flow of costs does not have to match the flow of the physical units. This is why LIFO is a cost flow assumption or an assumed flow of costs. (If the costs flowing matched the physical units flowing, it would be the specific identification method and there would be no need to assume a cost flow.)

Let's illustrate LIFO with a company that has three units of the same product in inventory. The units were purchased at different costs and in the following sequence: $40, $44, and $46. The company ships the oldest item (the one purchased for $40). However, under LIFO the company will report its cost of goods sold as $46 (the latest cost). Note that the last cost of $46 is the first cost out of inventory—the LIFO assumption. This means that the company's inventory will report the two first or oldest costs of $40 and $44.

LIFO has become popular because of inflation and the fact that the U.S. income tax rules permit companies to use LIFO. With LIFO a company is able to match its recent, more-inflated costs with its sales thereby reporting less taxable income than would occur under another cost flow assumption. Also, the matching of the latest costs with recent sales is a better indicator of the company's current profitability.