LIFO Inventory Valuation: Understanding Last-In, First-Out

LIFO (Last In, First Out) is the most common form of inventory valuation for the tax reporting of U.S. companies. Under LIFO, the most recent purchases (costs to the firm) of inventory are matched with current sales. In an inflationary environment this results in higher selling costs (basing firm cost of inventory on the most recent, most expensive inventory), and thus a lower net income. Lower net income means lower taxes, and consequently a higher cash flow from operations. Another benefit of using LIFO is that it is the most accurate representation of cost of goods sold, since the costs the inventory to the firm are based on the most recent purchase prices.

Comparing Companies that Use Different Methods

When comparing two companies that use different valuation methods, adjustments need to be made so that both are reported using the same method. This allows for a more realistic comparison, and usually involves converting LIFO inventory into FIFO due to the ease of the calculation. This is done by adding the LIFO reserve value to the value of the LIFO inventory of the LIFO firm. The LIFO reserve is the difference between a firm's LIFO inventory and FIFO inventory, and is reported by the company using LIFO.