LIFO (Last In First Out): When is the Method Used?

Efficient inventory management begins with choosing the right stock handling method and one widely used approach is LIFO, short for Last In, First Out. But what does this really mean in practice, and when is it the right choice? Rather than selling or using items in the order they were received, the LIFO method prioritizes the most recently added stock, making it the first to leave the warehouse. This rotation system has proven useful in various industries, particularly where products are non-perishable and prices fluctuate frequently.

The LIFO strategy goes beyond warehouse operations. It also affects how businesses value inventory, calculate costs, and report profits, especially during inflationary periods. For example, in a LIFO warehouse, the last batch of steel beams received would be the first sold, ensuring current market costs are reflected in the financial records. This simple example of LIFO highlights its practical impact on both logistics and accounting.

In this article, we'll break down the LIFO principle, walk through the LIFO procedure, and explore real-life scenarios where this method proves most beneficial for efficient operations and financial planning.

What is LIFO?

The LIFO definition describes a method where the most recently added is the first to be sold or shipped. Unlike FIFO (First In, First Out), where the oldest goods are prioritized, LIFO assumes the latest stock is used first. This affects how inventory is valued and how cost of goods sold (COGS) is calculated.

In times of inflation, LIFO accounting can reduce taxable income, since more expensive recent purchases are recorded as sold. It’s also practical in LIFO warehouse settings, where accessing newer goods first simplifies workflows, especially in high-density storage environments. However, LIFO use is restricted by some international standards, making it crucial to understand its limitations.

How to Calculate LIFO

Using the LIFO method, COGS is calculated based on the cost of the most recent purchases:

COGS (LIFO) = Latest purchase cost × Quantity sold

For example, if a company buys 100 units at €10 and 100 more at €12 and sells 120 units, LIFO assumes the 100 units at €12 are sold first, plus 20 from the earlier batch.  
Result:

• 100 × €12 = €1,200
• 20 × €10 = €200
• Total COGS = €1,400

The remaining inventory is the 80 units at €10. This approach often results in lower profits on paper and tax savings. For businesses, tracking LIFO inventory over time requires consistent processes and sometimes software support.

LIFO in Accounting

The LIFO (Last In, First Out) principle in accounting assumes that the latest inventory items purchased are the first ones sold. This method impacts the Cost of Goods Sold (COGS). During periods of inflation, LIFO results in a higher COGS because the most expensive, recently acquired goods are expensed first. This, in turn, leads to a lower reported profits and consequently reduced income taxes which is a significant advantage of LIFO for companies grappling with rising material costs.

While LIFO is accepted under US GAAP (Generally Accepted Accounting Principles), it is prohibited under IFRS (International Financial Reporting Standards). This significantly limits its use for international companies, as most countries outside the U.S., including Germany, adhere to IFRS or similar principles. In Germany, LIFO is generally not permitted under German commercial law (HGB - Handelsgesetzbuch) and tax law, primarily because it can lead to an understatement of inventory values and potentially distort the true economic performance of a business.

Implementing LIFO requires meticulous and consistent record-keeping. When applied in jurisdictions where it's allowed, LIFO accounting can offer businesses better cost matching, aligning the most recent costs with current revenues, and the potential for lower tax liabilities during inflationary periods.

LIFO in Inventory Management

In inventory management, the LIFO procedure ensures newer items are picked and shipped first. It’s useful for durable goods, like tools, parts, or raw materials, where product aging isn’t a concern.

LIFO works best in structured warehouse environments, such as block storage or high-density racks, where removing recent items is easier. It reduces handling complexity and aligns warehouse operations with financial strategies, especially during inflationary periods.

However, applying LIFO storage systems requires careful stock tracking and process discipline. When done properly, it improves logistics flow and supports a company’s financial goals, especially in fast-paced or heavy-goods industries.

Last In First Out: Areas of Application and Example

The LIFO method is primarily used in sectors where goods are non-perishable and prices fluctuate regularly, such as manufacturing, construction, metals, or chemicals. In these industries, applying the last-in, first-out strategy allows companies to align high recent costs with sales revenue, which is especially helpful for tax and cash flow optimization during inflation.

A common example of LIFO is a steel supplier receiving three shipments at rising prices. Under LIFO, the most recent (and most expensive) stock is sold first, increasing the cost of goods sold while lowering the remaining inventory’s value which is ideal for accurate profit reporting and financial planning.

How the LIFO Method Works

The last-in, first-out process works by removing the most recent inventory items first. This increases COGS when prices rise, thus reducing taxable income. The LIFO procedure is especially effective in inflationary periods, matching current costs with revenues and giving a more realistic profit margin.

If goods are bought at €5, €7, and €9 and three units are sold, LIFO records those sales in reverse order, resulting in higher reported costs and lower profit. To apply this method correctly, businesses need strong inventory systems to ensure data accuracy and compliance with accounting standards.

Overview of the LIFO Method

There are two main LIFO procedures: permanent and periodic. Both follow the same LIFO principle, but differ in update frequency and system complexity.

The Permanent Method

This real-time method updates stock values with each transaction. It requires a digital inventory system, making it suitable for high-turnover industries. It ensures alignment between accounting and warehouse data but depends on automated WMS platforms to function efficiently.

The Periodic Method

This simpler version updates stock data at regular intervals (e.g., monthly). It doesn’t need live tracking or advanced software, which makes it appealing to small businesses. However, it may lead to short-term data gaps, affecting reporting accuracy.

LIFO Storage Systems: Racking Systems

To implement LIFO in logistics, the storage infrastructure must support this method. The system must allow easy access to the newest stock, ensuring correct item rotation.

Rack Storage

Drive-in and push-back racking systems are commonly used for LIFO warehouse setups. In both, pallets are loaded and retrieved from the same side. These systems reduce aisle space while supporting efficient, high-density storage of durable goods.

Open-Air Storage

Outdoor LIFO storage is used for large, weather-resistant items like construction materials. Though cost-effective, it carries risks due to limited protection and automation and is best for goods with minimal handling needs.

High-Bay Warehouse

Advanced LIFO storage systems include automated high-bay warehouses using robotic cranes. These systems manage large inventories in compact spaces while applying LIFO rules through warehouse software. This setup is ideal for companies requiring speed, precision, and minimal labor.

Requirements for the Application of the LIFO Method

To implement the LIFO method, certain warehouse and accounting conditions must be in place. Physically, storage must support the last in first out principle, typically through single-sided racking or block stacking that allows quick access to the most recent inventory. This structure is ideal for goods without shelf-life concerns.

Operational consistency is critical. All warehouse processes should ensure that newer items are always picked first. Using a warehouse management system (WMS) that supports LIFO is highly recommended, helping track incoming goods by timestamp and ensuring proper item rotation.

In accounting, LIFO must be applied consistently once adopted. In countries like Germany, the LIFO procedure is accepted under commercial law, but businesses must maintain detailed documentation to stay compliant. Switching from LIFO to another method requires formal documentation and may result in tax implications.

When aligned with infrastructure, staffing, and legal rules, the LIFO process can support efficient stock handling and cost-saving inventory strategies.

Limitations of LIFO

Despite its benefits, the LIFO strategy has notable drawbacks. It’s not permitted under IFRS, limiting its use among globally active companies. Businesses using LIFO for local reporting often need a separate FIFO-based system for international compliance, increasing complexity.

LIFO is only suitable for non-perishable inventory. In sectors like food or healthcare, where products must be sold in the order received, FIFO is mandatory. Using LIFO storage systems in these cases could lead to waste or legal violations.

Logistically, LIFO can be inefficient when older inventory is needed. Reaching past newer stock may involve restacking or extra labor. This increases costs and the chance of stock damage, especially in busy warehouses with limited automation.

Additionally, tax benefits tied to LIFO depend on market conditions. If prices fall, older, cheaper stock remains on the books, leading to higher profits and more taxes. LIFO also risks maintaining outdated inventory values, complicating financial reports and forecasting.

In summary, while the last in first out process works in specific industries, it requires careful planning and is not suitable for every company.

Last In First Out: Advantages and Disadvantages

Before choosing LIFO, it’s important to weigh its pros and cons.

Advantages of LIFO

The biggest benefit of the LIFO procedure is its performance during inflation. Selling the most recently priced inventory first increases the COGS, lowering taxable income and improving cash flow. This is helpful for businesses managing tight liquidity.

The LIFO principle also gives more realistic profit figures in industries where prices change often. Companies see current costs reflected in their expenses, improving decision-making and planning.

From a warehouse perspective, LIFO storage systems can simplify operations for stackable, durable goods such as construction supplies or metal parts, where accessing newer stock is easier and more efficient.

Disadvantages of LIFO

However, LIFO’s global adoption is limited due to its ban under IFRS. Companies with international operations may face dual accounting and added reporting challenges.

LIFO can also distort inventory value. Old stock may remain unsold for years, creating a LIFO reserve that doesn’t reflect actual market value, confusing investors and auditors.

In logistics, following the last-in, first-out strategy may increase workload, especially in fast-moving or mixed-SKU environments. If prices fall, the previously helpful tax impact reverses, raising liabilities and affecting earnings reports.

FAQ

What is the difference between LIFO and FIFO?

The key difference lies in the order in which inventory is used or sold. Under the LIFO method (last-in, first-out), the most recently received goods are used or sold first. In contrast, FIFO (First In, First Out) assumes that the oldest stock is moved out first. This difference impacts financial results: during inflation, LIFO results in higher COGS and lower profits, while FIFO shows lower COGS and higher profits. The choice between FIFO and LIFO affects tax, reporting, and cash flow management.

Why is LIFO accounting prohibited in most countries worldwide?

The LIFO accounting method is banned under the International Financial Reporting Standards (IFRS) because it may distort a company’s actual financial health. By allowing businesses to use older, potentially outdated inventory values on their balance sheets, LIFO can obscure true value of assets. This lack of transparency is why most countries, especially those in the EU, only allow FIFO or weighted average methods for official financial reporting.

When does LIFO cause problems?

LIFO procedures can become problematic when inventory turnover is low, leading to outdated stock remaining in inventory indefinitely. This not only affects financial accuracy but also increases storage costs and risks product obsolescence. Additionally, in a deflationary market, LIFO may inflate profits, increasing tax liabilities. Operational issues also arise if warehouses are not configured for last in first out procedures, which can disrupt workflows and reduce efficiency.

Are there alternatives to LIFO?

Yes, several alternatives exist. The most common is FIFO, which is accepted under both GAAP and IFRS and often provides a better reflection of inventory age and value. Other methods include the weighted average cost and specific identification methods. In some industries, hybrid approaches are used, especially when inventory systems are complex or diversified. Choosing the right method depends on product type, turnover rate, and financial reporting requirements.

Can an entity switch between LIFO and FIFO?

Switching between LIFO and FIFO is possible but regulated. In jurisdictions where LIFO is permitted, such as the United States, switching to FIFO usually requires IRS approval and must be justified. Frequent changes are discouraged due to the impact on financial comparability. Moreover, companies that report under IFRS must use FIFO or other permitted methods, LIFO is not an option. For entities operating internationally, consistent use of FIFO is often more practical.