Definition of LIFO
Under LIFO, the most recent costs of products purchased (or manufactured) are the first costs to be removed from inventory and matched with the sales revenues reported on the income statement. This means that the oldest costs remain in inventory.
LIFO became popular due to inflation and the fact the U.S. income tax rules permit corporations (and other businesses) to use LIFO. With LIFO a corporation is able to match its recent, more-inflated costs with its sales thereby reporting less taxable income than would occur using another cost flow assumption. LIFO is justified because matching the latest costs with the latest sales revenues is a better indicator of the corporation's current profitability (as opposed to matching older lower costs with recent sales revenues).
It is important to understand that LIFO is a cost flow assumption and the flow of costs can be different from the flow of the physical units. In other words, under LIFO a corporation can ship its oldest physical units of product first, but can remove from inventory the cost of the most recently purchased items.
Example of LIFO
Assume that a corporation uses LIFO and has three units of a product in its inventory. Due to its supplier raising its prices, the corporation purchased the items at different costs and in the following sequence: $40, $44, and $46. The corporation ships the oldest item (the one purchased for $40) to a customer at a selling price of $60. However, under the LIFO cost flow assumption the company reports its cost of goods sold at $46 (the latest cost) and reports a gross profit of $14. (The costs of $40 and $44 remain in inventory.)
Had the corporation used FIFO, it would have removed $40 from inventory and matched it with the selling price of $60. The result would have been a gross profit of $20 (instead of $14 using LIFO). As a result, LIFO allowed the corporation to avoid paying income tax on the additional $6.