LIFO Inventory Method: What It Is, How It Works, and When to Use It

If you sell physical products, the way you value your inventory has a direct impact on your tax bill, your reported profits, and how investors see your business. LIFO—Last In, First Out—is one of the most powerful inventory valuation methods available to U.S. businesses, especially during periods of rising prices. Yet many small business owners overlook it entirely.

Here's what you need to know about LIFO, how it compares to FIFO, and why it's getting renewed attention in 2026.

What Does LIFO Mean?

LIFO stands for Last In, First Out. It's an inventory costing method that assumes the most recently purchased or manufactured items are the first ones sold. When you calculate your Cost of Goods Sold (COGS), you start with the cost of the newest inventory rather than the oldest.

This doesn't mean you physically ship your newest products first. LIFO is a cost flow assumption—it determines how costs move through your financial statements, not how goods move through your warehouse.

How LIFO Works: A Step-by-Step Example

Suppose you run a furniture business and purchase dining tables in three batches over the quarter:

Purchase	Units	Cost per Unit	Total Cost
January	100	$200	$20,000
February	100	$225	$22,500
March	100	$250	$25,000

Total inventory: 300 tables, $67,500 total cost

Now say you sell 150 tables during the quarter. Under LIFO, you assume the newest inventory sells first:

1. All 100 March tables at $250 each = $25,000
2. 50 February tables at $225 each = $11,250

LIFO Cost of Goods Sold: $36,250

Remaining inventory (150 tables):

• 50 February tables at $225 = $11,250
• 100 January tables at $200 = $20,000
• Ending inventory value: $31,250

Compare That to FIFO

Under FIFO (First In, First Out), the oldest inventory sells first:

1. All 100 January tables at $200 each = $20,000
2. 50 February tables at $225 each = $11,250

FIFO Cost of Goods Sold: $31,250

Notice the difference: LIFO produces $5,000 higher COGS than FIFO. When costs are rising, LIFO increases your cost of goods sold and decreases your taxable income.

Why LIFO Matters for Taxes

The tax advantage is the primary reason businesses choose LIFO. Here's the math:

• LIFO COGS: $36,250
• FIFO COGS: $31,250
• Difference: $5,000

If your effective tax rate is 25%, that $5,000 in additional COGS saves you $1,250 in taxes for the quarter. Scale that across a larger inventory and a full year, and the savings become significant.

According to Producer Price Index data from late 2025, some commodities saw dramatic year-over-year cost increases—copper mill products rose 26.2%, petrochemicals climbed 15.6%, and steel mill products increased 8.9%. For businesses dealing in these materials, LIFO can produce substantial tax deferrals.

LIFO vs. FIFO: Key Differences

Factor	LIFO	FIFO
Cost flow assumption	Newest costs first	Oldest costs first
COGS when prices rise	Higher	Lower
Net income when prices rise	Lower	Higher
Tax liability when prices rise	Lower	Higher
Ending inventory value	Lower (older costs)	Higher (newer costs)
Allowed under GAAP	Yes	Yes
Allowed under IFRS	No	Yes
Balance sheet accuracy	Less current	More current

The choice between LIFO and FIFO isn't just about taxes. FIFO tends to produce a more accurate balance sheet because ending inventory reflects recent prices. LIFO, on the other hand, better matches current costs against current revenue on the income statement.

When LIFO Makes Sense

Rising Costs and Inflation

LIFO delivers the greatest benefit when inventory costs are increasing. During inflationary periods, the gap between old and new inventory costs widens, making the tax deferral more valuable. With tariffs on imported goods ranging from 10% to over 100% in some categories, businesses that rely on imported raw materials or finished goods are finding LIFO especially attractive in 2026.

Large Inventory Holdings

If your business maintains significant inventory—manufacturing, wholesale distribution, retail—the tax savings from LIFO scale with the size of your inventory. A company with $10 million in ending inventory facing 10% cost inflation could defer roughly $300,000 in taxes by using LIFO instead of FIFO.

Long-Term Business Planning

LIFO benefits accumulate over time. The difference between your LIFO inventory value and what it would be under FIFO is called the LIFO reserve. This reserve grows year after year during inflationary periods, representing cumulative tax deferrals.

When LIFO Doesn't Make Sense

International Operations

LIFO is not permitted under International Financial Reporting Standards (IFRS). If your business operates internationally or plans to, using LIFO can create complications when consolidating financial statements across jurisdictions.

Declining Costs

When inventory costs are falling, LIFO actually increases your taxable income compared to FIFO. In a deflationary environment, the newest (cheaper) inventory gets expensed first, leaving the older, more expensive inventory on your books.

Seeking Investors or Loans

LIFO reduces your reported net income and your balance sheet inventory values. While this saves on taxes, it can make your financial statements look less attractive to lenders and investors who may not adjust for the LIFO effect.

The LIFO Reserve and LIFO Liquidation

Two important concepts come with LIFO:

LIFO Reserve

The LIFO reserve is the difference between what your inventory would be valued at under FIFO and its current LIFO value. Companies using LIFO are required to disclose this reserve in their financial statement notes. Analysts use it to compare LIFO companies with FIFO companies on an apples-to-apples basis.

LIFO Liquidation

LIFO liquidation happens when you sell more inventory than you buy during a period, dipping into older, lower-cost inventory layers. This creates an unintended profit spike—your COGS drops because you're now expensing those old, cheap units. The result is a one-time increase in taxable income that can catch businesses off guard.

To avoid LIFO liquidation, monitor your inventory purchasing patterns carefully and try to maintain or grow inventory levels throughout the year.

How to Adopt LIFO

Switching to LIFO requires planning and paperwork:

1. File Form 970 (Application to Use LIFO Inventory Method) with your timely filed tax return for the year you want to adopt LIFO.

2. Meet the book-tax conformity requirement. Under IRC Section 472(c), if you use LIFO for tax purposes, you must also use it for financial reporting. This is one of the few areas where the IRS mandates alignment between your books and your tax return.

3. Choose your LIFO calculation method. The most common approach is the Dollar-Value LIFO method, which measures inventory changes in dollar terms using price indexes rather than tracking individual units. This simplifies administration significantly for businesses with diverse product lines.

4. Maintain detailed records. The IRS requires adequate LIFO records for all periods the method is in use. Failure to maintain comprehensive documentation can result in the disallowance of your LIFO election.

5. Consult a tax professional. LIFO adoption is a significant accounting decision with long-term implications. The rules around LIFO recapture (when you might owe taxes on accumulated reserves) and method changes make professional guidance essential.

Other Inventory Valuation Methods

LIFO isn't your only option. Here are the alternatives:

• FIFO (First In, First Out): Assumes oldest inventory sells first. Most commonly used method worldwide and the default for many businesses.

• Weighted Average Cost: Averages the cost of all inventory available for sale during the period. Provides a middle ground between LIFO and FIFO.

• Specific Identification: Tracks the actual cost of each individual item. Best suited for businesses selling unique, high-value items like automobiles, jewelry, or real estate.

Tracking Inventory Costs Accurately

Regardless of which inventory method you choose, accurate record-keeping is the foundation. Every purchase, every cost change, and every sale needs to be captured correctly. Small errors in inventory valuation compound over time and can lead to significant discrepancies in your financial statements and tax returns.

Maintaining separate records for each inventory layer under LIFO requires a systematic approach. Many businesses use accounting software to automate the tracking, but even automated systems need regular review to ensure accuracy.

Keep Your Finances Organized from Day One

Whether you choose LIFO, FIFO, or another inventory method, the key to making the right decision starts with clean, well-organized financial records. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data—track every inventory purchase, every cost change, and every sale with precision. Get started for free and see why developers and finance professionals are switching to plain-text accounting.