The last-in, first-out (LIFO) method is an inventory valuation method which assumes that the most recent inventory purchases are sold first.
The LIFO method is one of three inventory valuation methods. The other two methods are the first-in, first-out (FIFO) method and the average cost method.
The LIFO and FIFO methods are inventory flow assumptions. These assumptions may not match the actual flow of inventory in the period.
Because prices are generally rising, LIFO accounting leads to a more accurate income statement since it captures the most recent costs. However, because older purchases remain in inventory, the LIFO method can significantly understate the balance sheet value of inventory.
As an example of the LIFO method, consider the following scenario. At the beginning of the month of February, a company has 500 units of inventory valued at $5 per unit for a total value of $2,500. On February 10th, the company buys 50 units of inventory at $5.25 per unit. On February 20th, the company buys 100 units of inventory at $5.50 per unit. Through the month of February, the company sells 300 units. In cost of goods sold, the company recognizes inventory sales in the following order: First the 100 units at $5.50 per unit purchased on February 20th; second the 50 units at $5.25 per unit purchased on February 10th. Last, 150 units from beginning inventory at $5 per unit. Total cost of goods sold for February is thus (100 x $5.50) + (50 x $5.25) + (150 x $5.00) = $1,562.50. The inventory balance at the end of the month is 350 units at $5 per unit, or $1,750.