In a period of inflation, the cost flow method that results in the lowest income taxes is the

The first-in, first-out (FIFO) inventory cost method assumes the oldest inventory is sold first. This leads to minimizing taxes if the prices of inventory items are falling. In this situation, the prices of the items purchased first are higher because the prices are downward trending and hence the cost of the previously purchased items of inventory (i.e. the first inventory in) is higher. This results in a higher company's cost of goods sold (COGS). Last-in, first-out (LIFO) assumes the most recent inventory purchases are sold first.

Using the higher inventory costs (first in) would lead to a lower reported net income or profit for the accounting period (versus last out). As a result, the lower net income would mean the company would report a lower amount of profit used to calculate the amount of taxes owed.

  • If a company uses the FIFO inventory method, the first items purchased and placed in inventory are the ones that were first sold.
  • If the older inventory items were purchased when prices were higher, FIFO would lead to a higher cost of goods sold and lower net income when compared to LIFO.
  • Lower net income would mean less taxable income and ultimately, a lower tax expense for that accounting period. 

When companies generate their financial statements, they must calculate the revenue generated from sales, the costs that went into production (or COGS), and also the profit earned for that time period. A company would take the revenue total and subtract the inventory costs (as well as other expenses), to determine how much profit was earned.

Companies must determine which items in inventory were used up in generating the sales for that accounting period as well as the costs of those inventory items. If a company uses the FIFO inventory method, the first items that were purchased and placed in inventory are the ones that were first sold. As a result, the inventory items that were purchased first are recorded within the cost of goods sold, which is reported as an expense on the company's income statement.

In other words, with the FIFO method, the oldest inventory will be used in determining the cost of goods sold. When sales are recorded for the accounting period, the costs of the oldest inventory items are subtracted from revenue to calculate the profit from those sales.

Although companies want to generate higher profits with each passing year, they also want to reduce their taxable income. If a company's inventory costs rose by 50%, for example, the company would report a lower amount for net income, assuming sales prices weren't increased to counter the higher inventory expense. A lower net income total would mean less taxable income and ultimately, a lower tax expense for the year.

The FIFO method can help lower taxes (compared to LIFO) when prices are falling. However, for the most part, prices tend to rise over the long term, meaning FIFO would produce a higher net income and tax bill over the long term.

If the older inventory items were purchased when prices were higher, using the FIFO method would benefit the company since the higher expense total for the cost of goods sold would reduce net income and taxable income. The newer, less expensive inventory would be used later, meaning the company would report a higher profit in later accounting periods and a higher taxable income—all else being equal.

However, prices tend to rise over the long term, meaning that FIFO may not minimize taxes for a company. In a rising-price environment over the long term, the older inventory items would be the cheapest, while the newer, recently purchased inventory items would be more expensive.

FIFO would only minimize taxes in periods of declining prices since the older inventory items would be more expensive than the most recently purchased items. It's best to consult a tax professional before determining the best methods for reducing taxable income since there are many components that go into calculating a company's tax liability.

Last in, first out (LIFO) is a method used to account for inventory that records the most recently produced items as sold first. Under LIFO, the cost of the most recent products purchased (or produced) are the first to be expensed as cost of goods sold (COGS), which means the lower cost of older products will be reported as inventory.

Two alternative methods of inventory-costing include first in, first out (FIFO), where the oldest inventory items are recorded as sold first, and the average cost method, which takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine COGS and ending inventory.

  • Last in, first out (LIFO) is a method used to account for inventory.
  • Under LIFO, the costs of the most recent products purchased (or produced) are the first to be expensed.
  • LIFO is used only in the United States and governed by the generally accepted accounting principles (GAAP).
  • Other methods to account for inventory include first in, first out (FIFO) and the average cost method.
  • Using LIFO typically lowers net income but is tax advantageous when prices are rising.

Last in, first out (LIFO) is only used in the United States where all three inventory-costing methods can be used under generally accepted accounting principles (GAAP). The International Financial Reporting Standards (IFRS) forbids the use of the LIFO method.

Companies that use LIFO inventory valuations are typically those with relatively large inventories, such as retailers or auto dealerships, that can take advantage of lower taxes (when prices are rising) and higher cash flows.

Many U.S. companies prefer to use FIFO though, because if a firm uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to shareholders, which lowers net income and, ultimately, earnings per share.

When there is zero inflation, all three inventory-costing methods produce the same result. But if inflation is high, the choice of accounting method can dramatically affect valuation ratios. FIFO, LIFO, and average cost have a different impact:

  • FIFO provides a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value COGS. Increasing net income sounds good, but it can increase the taxes that a company must pay.
  • LIFO is not a good indicator of ending inventory value because it may understate the value of inventory. LIFO results in lower net income (and taxes) because COGS is higher. However, there are fewer inventory write-downs under LIFO during inflation.
  • Average cost produces results that fall somewhere between FIFO and LIFO.

If prices are decreasing, then the complete opposite of the above is true.

Assume company A has 10 widgets. The first five widgets cost $100 each and arrived two days ago. The last five widgets cost $200 each and arrived one day ago. Based on the LIFO method of inventory management, the last widgets in are the first ones to be sold. Seven widgets are sold, but how much can the accountant record as a cost?

Each widget has the same sales price, so revenue is the same, but the cost of the widgets is based on the inventory method selected. Based on the LIFO method, the last inventory in is the first inventory sold. This means the widgets that cost $200 sold first. The company then sold two more of the $100 widgets. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100. In contrast, using FIFO, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200.

This is why in periods of rising prices, LIFO creates higher costs and lowers net income, which also reduces taxable income. Likewise, in periods of falling prices, LIFO creates lower costs and increases net income, which also increases taxable income.