LIFO is an inventory accounting method, in which the marketer and manager believe the items you have purchased recently will be the first one to be sold. Let’s say you bought a set of 10 electronic kitchen appliances, two years ago for Rs.10,000 each. A month ago, you purchased another lot of the same appliances for a higher price. Suppose you purchased the second lot for Rs. 15,000 per appliance.
If you follow the Last in First Out or LIFO inventory Accounting strategy, then you sell the products you had purchased recently. That’s because a second lot of electronic appliances are more expensive. Not only does it help you pay the expensive items at a high rate, but LIFO is specifically used to save money on the Taxes for the year. Since the second lot of electronic appliances is no longer in the inventory, you don’t have to use them while calculating the taxes for the financial year.
In other words, the LIFO accounting method assumes that the items you brought into your business most recently are sold first. This includes Raw Materials, finished goods, salable assets, and other items. As the name implies, the last purchased product will be the first item to be sold. It is the opposite of the FIFO (first in first out) method that assumes the oldest items in the inventory must be the first one to be sold. Since the price of the products keeps rising, the latest inventory will cost you higher than the products you had purchased a few years ago.
By selling the products that cost you higher, you will generate a lower profit and low tax Income. The only purpose of a company to follow the LIFO accounting strategy is to reduce the amount of tax they are liable to pay. One important thing to note here is that LIFO does not help you generate high profits. That’s because the same electronic appliance you purchased for Rs.10,000 two years ago will not cost the same if you purchase it today.
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Due to Inflation and other Market factors, it is assumed that the price of the product will increase. Now that you have purchased the product for a high price, you will make lower profits from its sale. That’s one of the reasons why LIFO is not the best inventory accounting method. In fact, only the government of the United States has allowed the businesses to use the Last in First out method.
LIFO might seem to work for some businesses, but it is not a practical solution. You will never be able to sell the oldest inventory. Eventually, it will get obsolete. Businesses will end up making room for the new inventory by pushing the older stocks in the back. As a result, you will get to a point where the older inventory will no longer be salable. That being said, LIFO is not the best way to run your business.