Knowing how to manage your inventory is essential as a business proprietor or manager. An important element of inventory management is accounting for COGS. In the US, almost 40% of wholesale companies utilize inventory accounting to reduce taxable income during inflationary periods. One of these techniques is Last in, First Out (LIFO), that may significantly alter how your company reports financials, particularly when prices rise.
In this article, we will see how LIFO inventory accounting works, when to make use of it, and how it could benefit your company. We will also see the role of outsourcing accounting services in managing this kind of accounting for your business.
What is LIFO?
LIFO means Last In First Out. It is a way of accounting to track and report inventory costs. That is to say that once you use LIFO you think the last things you added to your inventory are the first items you'll sell. This is useful if the cost of inventory changes, like during inflation periods.
For instance, you operate a shop and you purchased stuff for your inventory in the past several months. You bought 100 items at USD 50 apiece in January and 100 at USD seventy five apiece in March. In case you sell 100 items in April, LIFO accounting will presume you sold the items you bought in March at USD seventy five each even if the customer actually got something which was part of your January purchase.
Why Does LIFO Matter?
The LIFO technique can help businesses with inflation or rising costs. Whenever prices go up, LIFO matches the latest, higher costs to your sales revenue. This could reduce your taxable income because higher costs mean lower reported profits.
As an example, in case you sell a product which costs USD 75 and your sale price is USD 100, the profit is USD 25 under LIFO. But if you used an older purchase price of USD 50 (like In the FIFO method where first in, first out assumes the oldest goods are sold first) your profit will be USD 50 for the very same sale. The higher profit seems good but it means even more taxes. LIFO lowers your taxable income in case prices are rising.
LIFO vs Other Inventory Accounting Methods
LIFO isn't the only inventory accounting technique. Let us compare it to two other typical methods : FIFO & Average Cost.
1. FIFO (First In, First Out)
You assume under FIFO that the oldest inventory gets sold first. That leads to lower COGS at inflation, higher profits and higher taxes because you're using the older, cheaper inventory. FIFO reflects the current inventory value better because older costs match today's sales costs.
2. Average Cost Method
This particular technique computes the cost of goods sold based on the typical cost of all things in your inventory. This method smooths out lows and highs of cost changes and provides you with a middle ground between FIFO and LIFO. It helps when you have plenty of inventory with changing prices.
Each method has advantages and disadvantages, and the right option for your business depends on your financial objectives and market conditions.
When to Use LIFO?
LIFO helps most with inflation. Whenever prices are increasing, you can make use of LIFO to offset the increased price of your latest inventory. This may be an extremely advantageous tax-saving technique for organizations in industries with high variability of inventory expenses including retail, manufacturing, and auto.
For instance, say you run a hardware store. You purchase tools and materials routinely and prices have been increasing due to supply chain interruptions. You're purchasing inventory at progressively higher prices, though you have some older, cheaper things in stock. With LIFO, you match your product sales with the most expensive thing you purchased, cutting your reported profit and, thereby, your taxes.
Conversely, in case prices are dropping (a period of deflation) LIFO may be the wrong choice because the lower costs would be noted first and that would raise your taxable income.
The Drawbacks of LIFO
LIFO has some drawbacks other than tax advantages. A significant disadvantage is that LIFO might understate the value of your ending inventory. Since you are assuming the final, most costly items sold first, what is left in your inventory is worth much less than its real market value. This might make your company's balance sheet appear less favorable for lenders or investors.
An additional issue is that LIFO isn't allowed by the International Financial Reporting Standards (IFRS) which are adopted in nearly all countries. In case your business is internationally active or wants to grow worldwide, LIFO might be restricted because only the United States permits it under GAAP.
Also, businesses must use LIFO consistently, which implies that in case you make use of LIFO for tax reporting, you have to make use of it for your financial reporting to shareholders. The lower net income on paper might alienate investors despite the tax advantages.
Is LIFO Right for Your Business?
Whether to make use of LIFO is determined by your business financial situation and future goals. In case you operate in a business where prices have a tendency to rise as time passes such as retail or even manufacturing, LIFO might be useful to manage your taxes. But in case you wish to attract investors or expand worldwide, LIFO might not be the very best fit due to how it impacts net income and inventory valuation.
Final Thoughts
LIFO inventory accounting is a method of tracking tax liabilities during high cost periods for businesses. Presuming the last items added to inventory are the first items sold, businesses reduce taxable income and conserve cash flow. But this approach has disadvantages too - particularly with regards to the monetary impact on your company. Lastly, the usage of LIFO should be based on your unique financial objectives and industry trends.
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