Advantages and disadvantages of last-in, first-out (LIFO) method

Advantages of last-in first-out (LIFO) method:

The employment of LIFO is very common among companies worldwide because of the following benefits:

(1). LIFO matches most recent costs against current revenues:

The LIFO method provides a better measurement of current earnings by matching most recent costs against current revenues.

The non-LIFO methods (such as FIFO method) match old costs against current revenues. When old costs are matched against current revenues in an inflationary environment, the inventory profit (also known as ‘paper profit’ or ‘transitory profit’) is created. Inventory profit occurs when replacement cost of inventory is more than the inventory cost matched against revenues. This inventory profit understates cost of goods sold (COGS) and overstates profit.

The LIFO helps in reducing the inventory profits by matching the most recent costs against revenues. It results in reduction of understatement of cost of goods sold (COGS) and overstatement of profit. Therefore the quality and reliability of earnings are improved under LIFO.

 (2). Tax benefits and improvement in cash flows:

The major reason of the popularity of last-in, first-out (LIFO) inventory valuation method is its tax benefit. When LIFO is used in the periods of inflation, the current purchases at higher prices are matched against revenues that alleviate the overstatement of profit and therefore reduce income tax bill. The reduction in income tax results in improvement of cash flows of the company.

 (3). LIFO minimizes write-downs to market:

The net income of a company that uses LIFO is less likely to be affected by decline in price in future. Usually, the companies using LIFO method do not have much inventory at current higher prices because, under this method, most recent inventory purchased at higher price is sold first. So the chances of write-downs to market in future due to decline in inventory prices are minimized or even eliminated under LIFO.

(4). Physical flow of inventory:

In some situations, the physical flow of inventory corresponds to the LIFO cost flow. For example, in the case of a coal pile, the most recent coal added to the coal pile is always on the top of the coal pile. Therefore, the last coal in is always the first coal out.

This benefit is not a reason of the popularity of LIFO method because the situations where physical flow of inventory corresponds to the LIFO cost flow are very rare to find. The benefit 1, 2 and 3 described above are the main arguments of the widespread employment of this method.

Disadvantages of last-in, first-out (LIFO) method:

The major drawbacks of using LIFO as inventory costing method are given below:

(1). Reduced earnings in inflationary times:

The LIFO method reduces reported earnings during the periods of inflation. Therefore, many companies fear that an accounting change to LIFO will have a negative effect on investors and will reduce the price of company’s stock because many investors may not be able to understand the impact of LIFO and inflation on the reported earnings.

(2). Understatement of inventory:

Under LIFO method, the balance sheet inventory figure is usually understated because it is based on the oldest costs. Due to understatement of inventory, the working capital position may look worse than it really is.

(3). Problem of LIFO liquidation:

The LIFO liquidation may inflate the reported income for a given period that results in higher tax payments for the period. To avoid this problem, a company may purchase goods in large quantities with the intention to match them against revenues. Therefore, the adoption of LIFO may develop poor buying habits among companies.

(4). Manipulation of income:

A company using last-in, first-out (LIFO) method can easily manipulate its reported earnings for a period by changing its purchase pattern at the end of the year.

Practice exercises and problems