LIFO Liquidation Explained: A Comprehensive Guide

LIFO liquidation refers to the practice of discount selling older merchandise in stock or materials in a company’s inventoryInventoryInventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a. It is done by companies that are using the LIFO (last in, first out)Last-In First-Out (LIFO)The Last-in First-out (LIFO) method of inventory valuation is based on the practice of assets produced or acquired last being the first to be inventory valuation method. The liquidation occurs when a company using LIFO wants to get rid of old and perhaps obsolete inventory quickly.

Understanding LIFO Liquidation

LIFO liquidation can distort a company’s net operating incomeOperating IncomeOperating income is the amount of revenue left after deducting the operational direct and indirect costs from sales revenue., which generally leads to higher taxable income. Under LIFO, a company uses the most recent costs when selling inventory itemsInventoryInventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a. The fewer the number of purchases made, or items produced, the further the company goes into their older inventory.

When they begin selling inventory beyond that most recent purchase, the process is known as liquidation. As the company goes further back into their LIFO layers, they begin to sell their older, lower-cost inventory reserves. The process provides a lower cost of goods sold (COGS)Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct, which increases gross profits, and generates more income to be taxed.

Why LIFO Liquidation Occurs

There are several reasons why LIFO liquidation occurs, including:

• A sudden cash flowCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF problem within the company
• An unexpected spike in demand for the goods the company sells
• A lack of more recent inventory (either because of failure/inability to buy or an issue with production)
• The need to relocate or get rid of inventory, most likely due to a desire for storage space for newer and/or more goods that fit in with the wants and needs of consumers

At the end of the day, companies are reluctant to match the lower cost of goods from their old inventory with the current higher sales prices. When put head to head, it artificially generates higher gross margins and profits, attracting more income tax.  Such a preference drives management to avoid LIFO liquidations or at least to strategically manage when they occur.

LIFO liquidation is often executed when current profits are low or when management is trying to keep their warehouses at low levels.

Related Readings

We hope you’ve enjoyed reading CFI’s explanation of LIFO Liquidation. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Days Sales in Inventory (DSI)Days Sales in Inventory (DSI)Days Sales in Inventory (DSI), sometimes known as inventory days or days in inventory, is a measurement of the average number of days or time
• LIFO vs. FIFOLIFO vs. FIFOAmid the ongoing LIFO vs. FIFO debate in accounting, deciding which method to use is not always easy. LIFO and FIFO are the two most common techniques used in valuing the cost of goods sold and inventory.
• Inventory TurnoverInventory TurnoverInventory turnover, or the inventory turnover ratio, is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time.
• Perpetual Inventory SystemPerpetual Inventory SystemThe perpetual inventory system involves tracking inventory after every or almost every major purchase. In perpetual inventory systems, the