Last-In, First-Out (LIFO) is an Inventory accounting method that operates on a simple, if sometimes counterintuitive, principle: the last item you bought is the first one you sell. Imagine a pile of coal at a power plant. New coal is constantly dumped on top of the pile, and when the plant needs fuel, it scoops from the top. The newest coal is used first, while the old stuff sits at the bottom. In accounting terms, LIFO assumes that the most recently acquired inventory costs are the first to be moved to the Cost of Goods Sold (COGS) on the income statement. This means the costs you match against your revenue are the most current ones. This method is primarily used for financial reporting and tax purposes and often does not reflect the actual physical flow of goods, where older stock is typically sold first to avoid spoilage or obsolescence.
To understand LIFO, let's run a T-shirt shop. You are preparing for the summer season and buy your shirts in three batches as prices rise.
Now, you sell 150 shirts in June. How do you calculate your cost? With LIFO, you assume you sold your newest inventory first.
Your total COGS for the 150 shirts sold would be €1,500 + €600 = €2,100. What's left in your inventory? You have the 100 shirts from January (€10 each) and 50 shirts from March (€12 each). The inventory value on your Balance Sheet would be (€10 x 100) + (€12 x 50) = €1,600.
The choice between LIFO and its counterpart, First-In, First-Out (FIFO), isn't just an accountant's parlor game; it has real-world consequences for a company's reported profits, taxes, and balance sheet strength.
During periods of rising prices, known as Inflation, LIFO produces a higher COGS than FIFO. As seen in our T-shirt example, matching the latest, most expensive costs (€15 and €12) against revenue leads to a higher expense.
While lower profits might sound bad, there's a silver lining for the company: a lower tax bill. This tax benefit is the primary reason many U.S. companies stick with LIFO. Conversely, during periods of deflation (falling prices), LIFO would result in lower COGS and higher reported profits.
The flip side of LIFO is its effect on the balance sheet. Because the older, cheaper inventory is what remains on the books, LIFO can significantly understate the true economic value of a company's inventory. In our example, the remaining inventory is valued at €1,600, but its current replacement cost would be much higher. This creates what's known as “LIFO liquidation” risk, where a company might have to dip into old inventory layers, causing a sudden, artificial spike in reported profits and a big tax bill.
For a Value Investing practitioner, a company using LIFO requires a bit of detective work. LIFO reporting can obscure a company's true profitability and asset value, creating both pitfalls and opportunities.
A company using LIFO might look less profitable than a competitor using FIFO, purely because of its accounting choice. The inventory on its balance sheet will also look deceptively low. This is a classic case of accounting earnings differing from economic reality. The savvy investor needs to look past the reported numbers.
How can you compare a LIFO company to a FIFO company? The key is the LIFO Reserve. This is a figure that LIFO companies must disclose in the footnotes of their financial statements. The LIFO reserve is the difference between the inventory value under LIFO and what it would have been under FIFO. To make an apples-to-apples comparison, you can make two key adjustments:
This adjustment reveals the true economic value of the inventory and provides a more accurate picture of profitability, allowing for a fair comparison with peers.
One of the most important facts about LIFO is its geographic limitation.
This discrepancy is a major hurdle in comparing U.S. companies with their international counterparts. If you're analyzing a U.S. retailer and a European one, you must be aware of this difference and adjust the U.S. company's figures to a FIFO basis to get a clear and comparable view.