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LIFO (Last-In, First-Out) is an inventory cost-flow assumption in which the costs of the most recently acquired or produced Inventory are generally assigned to Cost of Goods Sold (COGS) first. LIFO can affect reported Inventory values, COGS, Gross Margin, and Net Income, particularly when inventory costs are changing.
Reading time: 9 minutes
Category: Inventory Accounting & Valuation
Definition: LIFO (Last-In, First-Out) is an Inventory accounting method that assumes the costs associated with the most recently purchased or produced units are assigned to Cost of Goods Sold (COGS) first.
The costs associated with older Inventory therefore generally remain in ending Inventory longer.
LIFO is a cost-flow assumption. It does not necessarily mean that a business physically sells its newest Inventory first.
For example, a company might physically ship its oldest products first to reduce spoilage, aging, or obsolescence while still using an allowable LIFO method for accounting purposes.
Suppose a company purchases the same product in two batches:
100 units at $10 each
followed by:
100 units at $12 each
The company then sells 100 units.
Under LIFO, the 100 units from the newer $12 cost layer would generally be assigned to COGS first.
Therefore:
COGS = 100 × $12 = $1,200
The older 100 units purchased at $10 each would remain in ending Inventory:
Ending Inventory = 100 × $10 = $1,000
Under FIFO (First-In, First-Out), the cost assignment would generally be reversed.
The $10 units would flow to COGS first, while the newer $12 units would remain in ending Inventory.
This difference can affect:
LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP) when applicable requirements are satisfied, but it is not permitted under International Financial Reporting Standards (IFRS).
That distinction is particularly important for businesses evaluating inventory accounting methods across different reporting frameworks.
Inventory costing methods determine how businesses assign costs between Inventory remaining on the Balance Sheet and Inventory recognized through COGS on the Income Statement.
When purchase or production costs change over time, different cost-flow assumptions can produce different financial results.
LIFO can affect:
During periods of rising Inventory costs, LIFO generally assigns more recent—and therefore potentially higher—costs to COGS first.
This can result in:
Higher COGS
and therefore potentially:
Lower Gross Margin and Net Income
compared with FIFO, assuming the relevant Inventory costs are rising and other factors remain the same.
At the same time, older and potentially lower costs may remain in ending Inventory.
If Inventory costs are falling, the relationship can work differently.
Businesses and financial statement users therefore need to understand which Inventory costing method is being used when evaluating Inventory values, margins, and profitability.
Several concepts are important for understanding how LIFO affects Inventory accounting.
LIFO assumes that the costs of the most recently acquired or produced Inventory are generally assigned to COGS first.
This is the defining characteristic of the method.
LIFO describes how Inventory costs are assigned for accounting purposes.
It does not necessarily describe how physical products move through a warehouse.
A business may physically sell older Inventory first while using a different permitted cost-flow assumption for accounting.
LIFO can create layers of Inventory costs from different purchase or production periods.
For example:
Layer 1: 100 units at $8
Layer 2: 100 units at $9
Layer 3: 100 units at $11
Under LIFO, the newest applicable cost layer is generally assigned to COGS first when units are sold.
Older layers can remain in Inventory for extended periods.
Because LIFO assigns newer costs to COGS first, changes in purchase or production costs can directly affect reported COGS.
When costs are rising, this commonly means newer, higher costs are recognized sooner.
Under LIFO, older costs may remain in ending Inventory.
If costs have increased significantly over time, the carrying amount of Inventory under LIFO may therefore differ substantially from amounts calculated using FIFO.
A LIFO liquidation can occur when Inventory quantities decline enough that older LIFO cost layers are used in calculating COGS.
If those older layers contain significantly lower costs than current Inventory purchases, this can affect reported COGS and profitability.
This is one reason businesses using LIFO need to understand both Inventory quantities and historical cost layers.
LIFO treatment depends on the applicable accounting framework.
LIFO may be used under U.S. GAAP when applicable requirements are met.
IFRS does not permit the LIFO cost formula.
Businesses operating internationally or comparing companies across reporting frameworks should therefore consider differences in Inventory accounting policies.
Example: Suppose a distributor purchases the same Inventory item in three batches during the year.
January
100 units at $10 each
April
100 units at $12 each
July
100 units at $14 each
The company therefore has:
300 units available
with a total cost of:
$1,000 + $1,200 + $1,400 = $3,600
The company then sells 180 units.
Under LIFO, the most recent costs are generally assigned to COGS first.
The first 100 units sold would come from the July cost layer:
100 × $14 = $1,400
The remaining 80 units would come from the April layer:
80 × $12 = $960
Therefore:
LIFO COGS = $1,400 + $960 = $2,360
The company has 120 units remaining.
Those units consist of:
20 units from April at $12 = $240
plus:
100 units from January at $10 = $1,000
Therefore:
Ending Inventory = $1,240
The accounting relationship is:
Goods Available for Sale = COGS + Ending Inventory
In this example:
$3,600 = $2,360 + $1,240
Now compare that with FIFO.
Under FIFO, the oldest costs would generally be assigned to COGS first.
The first 100 units would be:
100 × $10 = $1,000
The next 80 units would be:
80 × $12 = $960
Therefore:
FIFO COGS = $1,960
Ending Inventory would consist of:
20 units at $12 = $240
plus:
100 units at $14 = $1,400
Therefore:
FIFO Ending Inventory = $1,640
In this rising-cost example:
LIFO COGS: $2,360
FIFO COGS: $1,960
Difference:
$400
And:
LIFO Ending Inventory: $1,240
FIFO Ending Inventory: $1,640
Difference:
$400
Assuming the same sales Revenue and other Expenses, LIFO would therefore produce a lower Gross Margin and lower Net Income than FIFO in this simplified example.
This demonstrates the fundamental effect of the two cost-flow assumptions when Inventory costs are rising:
LIFO → newer, higher costs generally reach COGS sooner
FIFO → older, lower costs generally reach COGS sooner
If costs were declining instead of increasing, the results could be reversed.
LIFO can become more complex than simply assigning the newest Inventory cost to the next sale.
Businesses using LIFO may need to maintain historical cost layers, monitor changes in Inventory quantities, apply the method consistently, and understand how changing purchase costs affect COGS and ending Inventory.
Common LIFO challenges include:
Another challenge is that operational teams may assume LIFO determines how products should physically move through a warehouse.
That is not necessarily the case.
A company may physically ship older products first because of shelf life, expiration dates, obsolescence risk, or warehouse practices while using an allowable LIFO cost-flow assumption for accounting purposes.
The distinction is important:
Physical Inventory flow → Which actual units are received, stored, picked, and shipped
Inventory cost flow → Which costs are assigned to COGS and ending Inventory
The two do not necessarily have to be identical.
LIFO can affect both the Income Statement and Balance Sheet because it determines which Inventory costs are assigned to COGS and which remain in ending Inventory.
Under LIFO, newer Inventory costs are generally assigned to COGS first.
During periods of rising costs, this can result in higher COGS compared with FIFO.
Gross Margin is affected by COGS.
If LIFO produces higher COGS during a period of rising costs, Gross Margin will generally be lower than it would be under FIFO, assuming the same Revenue.
Higher COGS reduces Gross Margin and, all else being equal, reduces Net Income.
The Inventory costing method can therefore affect reported profitability even though the company's physical sales activity is unchanged.
Because older cost layers may remain in Inventory under LIFO, ending Inventory can be lower than under FIFO during sustained periods of rising costs.
Inventory is an Asset.
Differences in ending Inventory therefore affect total Assets reported on the Balance Sheet.
Businesses, lenders, investors, and other financial statement users may need to understand which Inventory method is being used when comparing:
Two companies with similar physical Inventory and sales activity can report different accounting results if they use different permitted Inventory costing methods.
LIFO and FIFO are both Inventory cost-flow assumptions, but they determine which Inventory costs are assigned to COGS first.
Under LIFO:
Newest Inventory costs → COGS first
Older Inventory costs → remain in ending Inventory longer
Under FIFO:
Oldest Inventory costs → COGS first
Newer Inventory costs → remain in ending Inventory
If Inventory purchase costs are increasing over time, LIFO will generally assign the newer, higher costs to COGS sooner.
Compared with FIFO, this commonly results in:
Higher COGS
Lower ending Inventory
Lower Gross Margin
Lower Net Income
assuming all other factors remain the same.
FIFO generally produces the opposite result during the same rising-cost environment:
Lower COGS
Higher ending Inventory
Higher Gross Margin
Higher Net Income
If Inventory costs are declining, the relationship can reverse.
LIFO may assign newer, lower costs to COGS first, while older, higher costs remain in Inventory.
Therefore, statements such as "LIFO always produces higher COGS" are incorrect.
The result depends on how Inventory costs are changing.
Neither LIFO nor FIFO necessarily determines how Inventory must physically move through a warehouse.
The terms describe accounting cost-flow assumptions.
Businesses may use operational practices based on shelf life, product age, expiration dates, warehouse layout, or other considerations.
Another important difference involves the applicable financial reporting framework.
U.S. GAAP → LIFO may be permitted when applicable requirements are satisfied
IFRS → LIFO is not permitted
FIFO, by contrast, may be used under both U.S. GAAP and IFRS when applicable requirements are met.
This difference is important when comparing U.S. companies with businesses reporting under IFRS.
A LIFO liquidation can occur when a business using LIFO reduces its Inventory quantities enough that older Inventory cost layers are used in determining COGS.
This can have a significant effect when older Inventory layers contain costs that are substantially different from current purchase costs.
For example, suppose a company has older Inventory layers recorded at:
$8 per unit
while newer Inventory purchases cost:
$15 per unit
Normally, under LIFO, the newer $15 costs would generally be assigned to COGS first.
However, suppose the company sells significantly more Inventory than it purchases during the period.
Eventually, some of the older $8 cost layer may enter COGS.
Instead of recognizing a $15 cost for those units, the company may recognize the older $8 cost.
The difference is:
$15 − $8 = $7 per unit
Using the older, lower-cost layer can reduce reported COGS and increase reported Gross Margin and Net Income compared with what results might have been if current replacement costs had been available.
This increase in reported profitability does not necessarily mean that the company's underlying operating economics improved.
It may result partly from the liquidation of historical LIFO cost layers.
For that reason, significant reductions in Inventory quantities can be important when analyzing the financial results of a business using LIFO.
Accurate Inventory accounting depends on maintaining reliable information about Inventory quantities and costs.
The level of complexity increases as businesses add more products, suppliers, locations, transactions, and changing purchase costs.
A very small business may maintain Inventory purchase and cost information manually.
This can become difficult as transaction volume increases.
Businesses may use spreadsheets to track:
Spreadsheets provide flexibility but can create risks involving:
Software can help businesses maintain information related to:
The specific Inventory costing methods available depend on the software and its configuration.
For product-based businesses, Inventory costs are connected to a broader transaction cycle.
For example:
Purchase Order → Receiving → Inventory → Sale → COGS → Financial Statements
Maintaining those transactions within connected systems can reduce the need to manually transfer Inventory and accounting information between separate applications.
Inventory costing requires accurate information about purchases, quantities, receipts, sales, adjustments, and item costs.
Depending on system capabilities, Inventory and accounting software can help businesses:
Businesses should verify which Inventory costing methods a particular system supports and whether those methods meet their accounting requirements.
CustomBooks connects Inventory with purchasing, receiving, sales, Accounts Payable, accounting, and other operational information.
This connected approach can help product-based businesses maintain visibility into the transactions that influence Inventory quantities, Inventory costs, COGS, and financial results.
The appropriate Inventory costing method remains an accounting-policy decision that should reflect applicable accounting and reporting requirements.
To better understand LIFO and its effect on Inventory accounting, these related glossary terms may also be helpful:
LIFO stands for Last-In, First-Out.
It is an Inventory cost-flow assumption under which the costs associated with the most recently acquired or produced Inventory are generally assigned to COGS first.
Older Inventory costs therefore tend to remain in ending Inventory longer.
LIFO generally assigns the newest Inventory costs to COGS first.
FIFO generally assigns the oldest Inventory costs to COGS first.
When Inventory costs are rising, LIFO will generally result in higher COGS and lower ending Inventory than FIFO, assuming other factors remain the same.
No.
LIFO is an accounting cost-flow assumption and does not necessarily describe the physical movement of Inventory.
A company can physically move older Inventory first while using an allowable accounting cost-flow assumption that differs from the physical movement of goods.
When Inventory costs are rising, LIFO generally assigns newer and higher costs to COGS first.
Compared with FIFO, this can result in higher COGS, lower Gross Margin, lower Net Income, and lower ending Inventory, assuming other factors remain the same.
LIFO may be used under U.S. GAAP when applicable requirements are satisfied.
However, LIFO is not permitted under IFRS.
Businesses should determine which accounting framework and Inventory accounting requirements apply to their circumstances.
Accurate Inventory accounting depends on more than knowing how many units are currently in stock.
Purchasing, receiving, item costs, Inventory adjustments, sales, Accounts Payable, COGS, and accounting activity can all influence financial results.
When these processes are maintained in disconnected systems and spreadsheets, businesses may spend significant time reconciling Inventory and accounting information.
CustomBooks connects Inventory with purchasing, receiving, sales, Accounts Payable, accounting, and other operational processes, helping product-based businesses maintain greater visibility into the transactions behind Inventory and financial activity.
Schedule a CustomBooks demo to see how integrated Inventory and accounting can provide better visibility across your product-based operations.
