If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long period of time, or when costs increase dramatically, the lower income tax payments will be significant.

Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. Under LIFO, the recent costs will be matched on the income statement with the recent sales revenues. (Recall that LIFO means the “last costs in” will be the “first costs out” of inventory and onto the income statement as the cost of goods sold.)

Let’s illustrate this with an example. A new company purchases aluminum for $1.00 per pound and sells it for $1.20 per pound. After several months, the company has 10,000 pounds of aluminum in inventory at a cost of $10,000. Its next purchase of 20,000 pounds came with a cost increase: the cost of aluminum increased to $1.10 per pound. The company immediately increased its selling price by ten cents per pound and sold 10,000 pounds of aluminum for $1.30 per pound. The company’s income statement will report sales of $13,000. The company must now match the cost of the 10,000 pounds of aluminum with the $13,000 of sales.

Under LIFO, the cost of goods sold will be $11,000 (10,000 lbs. sold X the recent cost of $1.10 per lb.). Using FIFO, the cost of goods sold will be $10,000 (10,000 lbs. sold X the first or older cost of $1.00 per lb.). How much gross profit did the company actually earn? Did it earn $2,000 ($13,000 – $11,000) as LIFO indicated? Or, did the company earn $3,000 ($13,000 – $10,000) as indicated by FIFO?

Business-savvy people will say the company earned only $2,000 from its main operating activity of buying and selling aluminum. They argue that the true profit is the amount remaining after you replace the 10,000 pounds of aluminum that was sold. If it will cost $1.10 per pound to replace the aluminum that was sold, the true profit is $2,000. The $3,000 computed under FIFO includes $1,000 of phantom or illusory profits. (In other words, the company was lucky to be holding 10,000 pounds of aluminum when the aluminum market increased by ten cents per pound.)

In our example, LIFO will mean $1,000 less of taxable income and $400 less in tax payments for a corporation with a combined federal and state income tax rate of 40%. That’s good for the company’s cash flow. It will help the company meet its payments to its suppliers for the higher costing aluminum.

Learn about Inventory & Cost of Goods Sold.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years. He is the creator and author of all the content found on AccountingCoach.com. You can read 1,500 testimonials praising his ability to explain accounting in a way that anybody can understand.

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