During times of inflation and rising prices, businesses benefit not only from the additional business but the receipts that they receive for their business offerings. In short, a business’ profitability improves, more or less. However, with the increasing profitability comes the scourge of taxation that has got to be dealt with also. Bearing this in mind, a business would benefit a whole lot if it could somehow overestimate its costs for the purpose of reducing its overall profitability on paper. This is where LIFO comes into the picture. Here is an account of how it can help businesses in saving on their tax bills:
How LIFO Works
LIFO stands for ‘Last-in-First-out’. It is a method used for the valuation of inventory, dictating that the newest product is the latest to be sold, for valuation purposes. Or, in other words, LIFO assumes that the sales that you make are from the top of your pile, considering how the newest items are lined up on the top. In times of inflation, however, the cost of every succeeding product is greater than the cost of the preceding ones, which is the reason why the employment of LIFO for inventory valuation bears such good benefits. The resultant profits would, thus, be understated, meaning that the tax liability of the business will not be as great as it would have been otherwise.
The Matching Principle
Businesses that make use of LIFO are better equipped to make use of the matching principle, unlike the companies that make use of FIFO. It is because LIFO charges costs and revenues from similar time periods. FIFO, on the other, charges costs from such a time period that might not even be relevant anymore. LIFO allows the accounting practices to be performed on the most recent currency values, which is in line with the matching principle.
Better Pricing Decision
We all know the importance of pricing products at the most optimum level, right? Well, LIFO can help a business in doing exactly that. If a business is making use of cost plus pricing, the usage of LIFO would mean that the cost of goods sold would be determined on the basis of the most recently purchased goods. This will help in covering the material costs in a much suitable and better manner than the usage of FIFO, for example. What this ultimately means is that the price of the product, based on LIFO, will recover material costs in a much better manner than the usage of FIFO, owing to how all of the estimations are made on the latest cost trends, rather than the trends of the past!
When you take it all into perspective, LIFO certainly does appear to be the ‘perfect’ inventory valuation solution, right? Well, it is important to remember that there is no such thing as ‘perfect’ and everything has got its share of pitfalls. If you would like advice on what the best inventory valuation method might be for your business, the experts at SKB Accounting would love to be of assistance!