LIFO Reserve

See: LIFO.

A place set aside for all the LIFOs to roam free. Okay, maybe not.

There are two basic ways companies account for their inventories: FIFO and LIFO. FIFO stands for "First In, First Out." LIFO stands for "Last In, First Out." (We here at Shmoop take a LIFO attitude to coming to work on Fridays.)

FIFO assumes that any item sold to a customer was the oldest peice of inventory in stock. It came into the warehouse first, so it was the first thing sent out.

LIFO makes the opposite assumption. Anything sold was the most recent item made. Products basically go from factory floor to customer. Anything left in the warehouse is the oldest inventory around.

The difference between LIFO and FIFO accounting comes down to the cost of producing a product.

You run a factory that makes designer salad tongs. In May, it cost an average of $12.25 to make one unit. In June, it cost $12.32.
If you make a sale at the end of June, FIFO would assume that the product you sold to the customer cost $12.25. The items made during May were the first product "in," therefore the first to go out.

LIFO would assume the tongs cost $12.32. They were the most recently made items (the last ones "in"), therefore the ones that went to customers first.

The decision between LIFO and FIFO matters in computing margins and profits and, eventually, tax liability. The different cost basis for each situation leads to different results for the various computations that go into making financial statements.

If you sell a tong to the public for $35, the gross profit for the May-produced items is $22.75 ($35 - $12.25). The gross profit for those manufactured in June is slightly less, at $22.68 ($35 - $12.32).

Now, a little economic truism: prices and costs usually trend upward over time. You've probably heard your grandparents talk about how a trip to the movies used to cost $2.50 and you could buy a new car for $5,000. The reason you can't get those prices anymore is because of inflation. Prices generally drift higher over time. As such, FIFO costs tend to be lower than LIFO. Since costs are constantly rising (on average), the "first in" products will have been cheaper to make than the "last in" products. You know, the $12.25 salad tongs vs. the $12.32 ones.

The LIFO reserve is an account that closes the gap between the two accounting methods. In the salad tong example, the LIFO reserve would be $0.07 per tong produced...the difference between $12.25 and $12.32. If you made 100,000 tongs during a financial period, with a $0.07 gap, you'd record a LIFO reserve of $7,000.