What is LIFO Liquidation?
LIFO liquidation refers to the practice of discount selling older merchandise in stock or materials in a company’s inventory. It is done by companies that are using the LIFO (last in, first out) inventory valuation method. The liquidation occurs when a company using LIFO wants to get rid of old and perhaps obsolete inventory quickly.
Understanding LIFO Liquidation
LIFO liquidation can distort a company’s net operating income, which generally leads to higher taxable income. Under LIFO, a company uses the most recent costs when selling inventory items. The fewer the number of purchases made, or items produced, the further the company goes into their older inventory.
When they begin selling inventory beyond that most recent purchase, the process is known as liquidation. As the company goes further back into their LIFO layers, they begin to sell their older, lower-cost inventory reserves. The process provides a lower cost of goods sold (COGS), which increases gross profits, and generates more income to be taxed.
Why LIFO Liquidation Occurs
There are several reasons why LIFO liquidation occurs, including:
- A sudden cash flow problem within the company
- An unexpected spike in demand for the goods the company sells
- A lack of more recent inventory (either because of failure/inability to buy or an issue with production)
- The need to relocate or get rid of inventory, most likely due to a desire for storage space for newer and/or more goods that fit in with the wants and needs of consumers
At the end of the day, companies are reluctant to match the lower cost of goods from their old inventory with the current higher sales prices. When put head to head, it artificially generates higher gross margins and profits, attracting more income tax. Such a preference drives management to avoid LIFO liquidations or at least to strategically manage when they occur.
LIFO liquidation is often executed when current profits are low or when management is trying to keep their warehouses at low levels.
We hope you’ve enjoyed reading CFI’s explanation of LIFO Liquidation. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.
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