Retail companies must manage their inventory effectively. This lesson defines the Last-In/First-Out method, identifies how it affects businesses, and describes scenarios where it may be the most effective way to manage inventory.
FIFO vs LIFO
There are several strategies that companies use in managing inventory. Certainly, some are more common than others. Some methods are so different from one another, they actually are functional opposites. Such is the case between the First-In/First Out method and the focus of this lesson, the Last-In/First-Out method.
To review, the First-In/First-Out method, or FIFO, is one of the most common methods used to manage inventory. In this strategy, as the name implies, the first items received as inventory to a business will be the first items that are sold to the public. Imagine a grocery store's perishable goods: the food items with the expiration dates that will come soonest are sold first to customers, while items that have more time before they go bad will be stored in the back, waiting for their turn on the shelves.
Quite the opposite, the Last-In/First-Out, or LIFO, strategy stipulates that the products most recently received by a company are used or sold first.
If you have ever had the opportunity to work in a retail store, you may have some personal experience with inventory that illustrates the LIFO method rather perfectly. Imagine that you are a store employee in charge of stocking shelves. You just received a new shipment of inventory and you place these newest items directly in front of the products already on the shelves, pushing them to the back wall. Customers who are going to make purchases will pull from the front of the stocked shelves and buy your new inventory, rather than the older items that got pushed to the back.
Uncommon and Legal Only in the US
The LIFO method of managing inventory is rather uncommon. For many businesses, like our grocery store, the safety or effectiveness of their products is time-sensitive. In any case where the goods are perishable, pushing the inventory to the back of the shelves to be sold months or even years later (or perhaps not ever sold at all) would be cost-ineffective; stores would lose money as their items go bad before they can be sold.
Likewise, it is not the appropriate method for products that have change orare updated frequently. For instance, if a company sells cell phones (a technology that is upgraded frequently), management will want to ensure they sell the phones they have in stock before they sell the newest models of phones. If they end up with phones that are two versions old, it is unlikely they will be able to sell them or will have to sell them at a huge loss. In such cases, FIFO is a far better strategy to manage inventory.
One reason why companies might choose to use the LIFO method is to try to offset inflation. Generally speaking, the cost of goods - including inventory - increases over time. This means, theoretically, items purchased a year ago were bought at a price lower than the price they cost now. If a company is able to sell the higher-priced inventory (that which was bought most recently) first, it can report its profits in a way that benefits taxes.
Because of the way the LIFO method can significantly affect the way a company reports its profitability for tax purposes, it is actually illegal to use everywhere but in the US. The LIFO strategy was banned in 2001 with the passing of the International Financial Reporting Standards and, because of this, is largely uncommon, even within the United States. By far, most businesses have gone back to the FIFO method.
Let's construct another example. Let's pretend you own and manage a tire store in Colorado. Your store does pretty well and you order new tires in on a regular basis to fill requests and re-stock inventory. Not only do you want to offer a wide variety of options to customers in general, but - considering Colorado winters - you have to change out tires seasonally to meet customers' safety needs. You have chosen to use the LIFO method for managing your inventory, so the most recently received tires are sold to customers first.
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Using the LIFO method in this case allows you to more easily accommodate seasonal requests. Knowing you will sell more snow tires in the winter, you need to order those tires in for seasonal use. You do have plenty of regular tires sitting in inventory, but those tires are not appropriate for icy weather and will be in demand when the weather improves.
The second reason your tire store uses LIFO to manage your inventory is for financial and tax purposes. Consider supply and demand. If you were to order snow tires in the summer, the supply is likely low and you may end up paying more for those tires than if you order them during the winter months. Additionally, if you pay more for tires and sell them at a loss, you have a loss of income that will affect your revenue and may affect your tax liability. Similarly, if you purchase snow tires in the winter and try to sell them in the summer, you may have purchased them at the best price, but you will likely have a difficult time selling them at a profit because snow tires are not needed in the summer.
Companies that use the Last-In/First-Out (LIFO) method of inventory management make available to customers the newest or most recent shipments of goods. In this strategy, the last product received is the first item sold.
The LIFO method is an uncommon form of inventory management because it is often inappropriate for perishable items (like food), frequently updated or improved goods (such as technology), and because it is illegal outside of the US.
However, the LIFO method has specific uses for products that fluctuate in supply and demand or products that have a constant change in price points. Used effectively, the Last-In/First-Out method can help ensure inventory is sold when demand is the highest, taking advantage of price breaks and customer needs. It can also affect the financial and tax situation of a company.
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