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.

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Finance: What is LIFO v FIFO?4 Views

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Finance Allah Shmoop What is life Oh versus Fife Oh

00:08

All right Well this videos everything you wanted to know

00:11

about how to count inventory but were afraid to ask

00:14

if you really were afraid Well might we suggest a

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visit soon to the Wizard Yes Soon Team life O

00:20

wants inventory to be counted based on the most recent

00:24

prices in the market place that's life O as in

00:27

last in First out So there is a war It's

00:30

not in the White House It's not China It's not

00:33

in the Middle East It's in the hallowed halls of

00:35

accounting firms everywhere Life Oh refers to inventory cost accounting

00:39

such that it counts the cost of the most recent

00:42

inventory acquired as the expense against revenues rather than the

00:46

first inventory acquired on what does all that mean All

00:49

right well let's look at Silly Putty a product vital

00:52

to the American psyche and built largely from highly volatile

00:56

Lee priced petroleum products All right Luckily for the sellers

00:59

of the Putty it last male almost forever And so

01:02

life O V Fi Foh becomes a big deal for

01:04

the putty they bought three years ago In the massive

01:07

shelf stocking exercise of two thousand sixteen The sellers of

01:11

party were paying two dollars an egg all in for

01:14

that product inventory But then three years later in our

01:17

current era after the great Somalian warlord rebellion had petroleum

01:22

costs skyrocketing such that the cost of the putty inside

01:25

that egg went from two bucks Tow three box and

01:28

they're still selling the putty thing there for five bucks

01:31

each right So life Oh style accounting would claim that

01:34

the expenses mapped against the five dollars per egg revenues

01:37

would be the last in egg prices Or that three

01:41

dollars and egg inventory unit cost showing a gross profit

01:45

of two dollars Had the company been using Ah fife

01:48

Oh style of accounting Well then they would have looked

01:50

to the three year old cost of a two dollar

01:52

an egg inventory cost and they would be showing a

01:55

three dollars per egg gross profit Yet another player in

01:58

the accounting Octagon That's what that looks like is what's

02:01

called the average cost of inventory calculation Where in well

02:06

here that average cost might be answer to fifty and

02:09

egg which would then give Ah fifty percent gross margin

02:11

or profit per egg sail on a five dollars selling

02:14

price of two Fifty Well why does all this matter

02:16

Well a few things heir issue here showing higher expenses

02:19

on the inventory shows lower accounting profit to the company

02:22

and it is on that operating profit that the company

02:25

is then taxed So if the company is able to

02:27

show less profits well then it simply pays less in

02:30

taxes But if the company is publicly traded well then

02:32

shareholders of the company I either owners likely get punished

02:36

in the public markets in the form of a lower

02:38

stock price at least for a while Because instead of

02:41

trading at twenty times earnings of three dollars twelve cents

02:43

a share or sixty two dollars in change the company

02:46

using the higher inventory cost now to show lower profits

02:51

well on Lee shows profits or earnings of two eighty

02:53

a share Still likely trading at that twenty times earnings

02:56

number for a fifty six ish dollars a share trading

02:59

price or roughly nine ish percent discount to where they

03:02

were trading Otherwise it's not quite that simple but that's

03:05

the idea In theory there are other adjustments that need

03:08

to get made on the company's balance sheet Then as

03:10

Well that is if the value of their inventory has

03:12

gone up some fifty percent and that inventory comprises a

03:16

meaningful amount of asset value to the company like you

03:18

know in the But he's going off from two to

03:20

three bucks Well then the decision is whether that inventory

03:23

should be held at market value I eat the new

03:26

higher price three dollars an egg putty or at the

03:29

acquisition cost i e The historical Three years ago two

03:33

dollars per egg putty For the old units that were

03:35

acquired a more middle of the road number would be

03:38

just that average cost thing at two fifty or average

03:41

adjusted book value Cost these numbers in a vacuum don't

03:44

mean a whole lot But in a highly volatile industry

03:46

like this one or rather industries with highly volatile expense

03:49

input the FIFA Life Oh smackdown can have huge changes

03:53

in reported company profits depending on which gets applied Think

03:57

airlines where fuel costs can run anywhere from twenty thirty

04:00

forty fifty send in the cost of running the airline

04:03

and in areas where fuel prices can double or triple

04:05

in a heartbeat and or get cut in half in

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a year or less Well you can imagine that the

04:10

reported earnings numbers would be a harder to wrestle down

04:13

then Well this guy

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