Understanding the LIFO Method: How It Works and When to Use It

As costs rise and markets fluctuate, retailers need to employ smart strategies to help protect their bottom line. One approach? The Last In, First Out (LIFO) method, which is an inventory valuation strategy that prioritizes the cost of your newest inventory for calculations. It’s often used by businesses in industries where costs fluctuate or inflation is a factor, helping them control expenses and keep operations running efficiently.

By using the cost of your most recent inventory, LIFO aligns your cost of goods sold with current market conditions. The result? It can lower taxable income, improve cash flow and impact overall profitability—especially for businesses with large or fast-moving inventories.

For retailers managing multiple locations or navigating growth, the LIFO method can be a practical way to handle rising costs while staying competitive. Knowing when and how to apply it correctly can make a world of difference.

• What is LIFO?
• Advantages of LIFO
• Disadvantages of LIFO
• When to use LIFO
• Practical tips for using LIFO effectively
• Key takeaways

What is LIFO?

LIFO is an inventory accounting method where the newest inventory is sold or used first. It’s a straightforward concept but has a big impact on how businesses calculate cost of goods sold (COGS) and the value of inventory on their balance sheets. Unlike its counterpart, FIFO (First In, First Out), which assumes older inventory is sold first, LIFO prioritizes the most recent costs.

LIFO becomes especially relevant during inflation. When prices rise, using the cost of newer, higher-priced inventory increases COGS. This reduces taxable income and, in turn, lowers taxes. The downside? Older inventory costs stay on the balance sheet, which can make the numbers look outdated and less reflective of current market values.

The LIFO method often works best for industries with rising costs, like retail, automotive and manufacturing. It matches higher expenses with current revenues, offering a clearer view of profitability when prices fluctuate. But there’s a catch: LIFO is only permitted under U.S. Generally Accepted Accounting Principles (GAAP) and is banned under International Financial Reporting Standards (IFRS), so it won’t work for businesses with global operations.

For businesses managing large inventories, LIFO is a practical way to control cash flow and manage taxes. By focusing on the most recent inventory costs, it aligns financial reporting with today’s market conditions—an advantage for navigating economic shifts.

Advantages of LIFO

Tax benefits during inflation

One of the biggest advantages of LIFO is its ability to lower taxable income when costs are rising. By using the most recent, higher-priced inventory to calculate the cost of goods sold, businesses can report lower profits on paper—leading to tax savings. Those savings can translate directly into more cash for reinvestment or day-to-day operations.

Better cash flow

Tax savings with LIFO aren’t just about cutting costs—they improve cash flow. During inflation, when expenses are climbing, having extra funds on hand can make a huge difference. Whether it’s for stocking up on inventory, expanding locations or covering operational needs, better cash flow gives businesses greater flexibility to act quickly.

Matching current costs to revenue

LIFO pairs today’s costs with today’s sales, which gives businesses a more accurate view of their profit margins. This is especially helpful when prices are unpredictable. By matching current expenses to current revenue, businesses can see how rising costs impact profitability in real time and allow them to make more informed decisions.

Simplicity in certain industries

For industries like manufacturing or construction, where stock doesn’t spoil or lose its appeal over time, LIFO can simplify operations. You don’t need to worry about rotating inventory or tracking older items closely. This straightforward approach can save time and reduce unnecessary complexities while keeping inventory moving efficiently.

The LIFO method isn’t just about taxes—it’s a practical tool for managing costs, cash flow and operations in industries where inflation and fluctuating prices are the name of the game.

Disadvantages of LIFO

Not accepted internationally

If you’re weighing the LIFO advantages and disadvantages, it’s important to note that this method isn’t allowed under International Financial Reporting Standards (IFRS). This makes it off-limits for businesses with global operations. Companies reporting internationally have to use methods like FIFO or Average Cost instead. This limitation means LIFO is only viable for businesses operating within the U.S. under GAAP.

Inventory understatement

One major downside is how LIFO affects inventory valuation. Older inventory costs stay on the balance sheet, which can understate the true value of your inventory. This creates a financial picture that doesn’t reflect current realities—potentially making it harder to attract investors or secure loans.

Higher reporting costs

Using LIFO can also lead to higher administrative costs. Tracking inventory layers and staying compliant with GAAP requires more time and expertise. Businesses often need specialized accounting support or advanced systems, both of which drive up expenses.

Unsuitable for perishable goods

For industries like food or pharmaceuticals, LIFO doesn’t work well. Selling newer items first while older inventory sits untouched increases the chance of spoilage or waste. In these cases, FIFO or other methods are a better fit for keeping inventory fresh and minimizing losses.

LIFO can be a useful tool, but it’s not without its flaws. Whether it’s added complexity, global restrictions or mismatched industry needs, understanding these challenges is essential for deciding if LIFO is the right fit for your business.

When to use LIFO

LIFO works best when inflation drives up costs. By using the most recent, higher-cost inventory to calculate the cost of goods sold, businesses can reduce taxable income—which frees up cash for reinvestment or daily operations. It’s a practical option for industries dealing with raw materials, machinery or durable goods, where prices tend to rise steadily and stock doesn’t spoil or lose value over time.

If minimizing tax liabilities and maintaining cash flow are priorities, LIFO is worth considering. It’s especially effective for businesses that don’t rely on older inventory, such as automotive dealerships, construction suppliers or retailers selling standardized, high-value goods. These businesses often use LIFO to match current costs to revenue, keeping profitability in line with market conditions.

When not to use LIFO

That said, LIFO isn’t the right fit for everyone. It’s prohibited under IFRS, so businesses operating globally can’t use it. It’s also less suited to industries handling perishable goods, like food or pharmaceuticals, where selling newer stock first risks leaving older inventory to spoil. In these cases, FIFO or other inventory methods are more effective alternatives for maintaining quality and avoiding waste.

LIFO shines in specific scenarios—industries facing inflationary pressures or managing durable goods often see the most benefit. But it’s less practical where compliance with global standards or product freshness is key. 

Understanding when to use it can have a significant impact on a retailer’s financial strategy. A reliable inventory management system, like Lightspeed’s POS system, can help track stock movements in real time, making it easier to manage costs and stay organized. 

Practical tips for using LIFO effectively

Evaluate industry suitability

LIFO is a smart choice for industries where inventory costs are steadily rising and products don’t spoil or lose value quickly. It’s a solid fit for sectors like automotive, raw materials and other durable goods. But if your business handles perishable items or operates under global accounting standards, LIFO might not be the right method.

Monitor inflation trends

LIFO thrives when inflation is driving up costs. By recording the most recent, higher-cost inventory as sold first, you can reduce taxable income and keep more cash on hand for operations. However, if the market stabilizes or prices drop, the benefits of LIFO can shrink, so it’s important to keep an eye on economic conditions.

Ensure compliance with tax regulations

LIFO is allowed under U.S. GAAP but not under IFRS, which means it’s off-limits for businesses reporting internationally. Make sure your jurisdiction permits LIFO and that your accounting practices follow local laws. Ignoring this step could lead to compliance issues, audits or fines.

Conduct regular inventory audits

Schedule regular audits to ensure your inventory records are accurate and avoid discrepancies in your financial reporting. With tools like Lightspeed Scanner, you can quickly scan and track stock levels using just your iPhone, reducing manual errors and saving you time. A more efficient auditing process means you can stay on top of inventory trends and make informed purchasing decisions with confidence and ease.

Consider hybrid inventory methods

If your business sells both durable and perishable items, a hybrid approach could work. Use LIFO for categories with rising costs and longer shelf lives while applying FIFO to perishable or time-sensitive inventory. This strategy helps you manage costs while reducing the risk of waste.

Leverage accounting software

The right accounting tools can make LIFO far easier to manage. Look for software that tracks inventory layers and integrates seamlessly with your financial systems. Lightspeed integrates with leading accounting platforms like QuickBooks and Xero, helping you automate data entry, sync daily sales totals and track profitability in real time. Automation minimizes errors, saves time and keeps your records consistent across all channels.

LIFO can be a game-changer if it’s applied intentionally and tailored to your business model. With the right approach and tools, it’s a powerful method for navigating rising costs.

Key takeaways

The Last In, First Out method prioritizes the most recent inventory costs when calculating cost of goods sold. It’s a practical option for businesses facing inflation, as it reduces taxable income and improves cash flow. Industries like retail, automotive and manufacturing often benefit the most, especially when handling non-perishable goods or managing steadily rising costs.

That said, LIFO does come with limitations. It’s only permitted under U.S. GAAP, so businesses following IFRS can’t use it. It’s also a poor fit for companies managing perishable goods. To apply LIFO effectively, businesses need accurate inventory tracking, dependable accounting systems and a strong grasp of market trends.

If you’re considering LIFO, start by evaluating your business’s financial needs and market conditions. For expert guidance on whether it’s the right choice, talk to an expert and explore how it can align with your goals.

FAQs

Which is easier, LIFO or FIFO?

LIFO and FIFO are both simple to apply, but the better fit depends on your goals. LIFO prioritizes selling newer inventory first, which can reduce taxable income during inflation. FIFO sells older inventory first, often leading to higher profits—and higher taxes. For a closer look at their differences, check out FIFO vs. LIFO: Comparing Inventory Valuation Methods.

What is LIFO reserve?

LIFO reserve is the difference between inventory costs under LIFO and FIFO. It shows how much taxable income has been deferred by using LIFO when costs rise. This number offers insight into tax savings and is typically included in financial statements for transparency. Learn more about it.