LIFO Reserve: Definition, Calculation, and Why It Matters
What is the LIFO reserve?
The LIFO reserve is the difference between inventory valued under the first-in, first-out (FIFO) method and inventory valued under the last-in, first-out (LIFO) method:
LIFO reserve = FIFO inventory − LIFO inventory
It is recorded as a contra-inventory account to reconcile the two valuation methods and enable comparability between companies using different inventory accounting policies.
Why the LIFO reserve exists
- Many companies use FIFO or standard costing for internal reporting (management, pricing, and investor presentations) but use LIFO for external reporting and tax filings.
- In periods of rising prices, LIFO charges more recent (higher) costs to cost of goods sold (COGS), producing lower reported pre-tax income and lower ending inventory compared with FIFO. The LIFO reserve captures that difference.
- Tracking the LIFO reserve lets analysts convert LIFO figures to FIFO (or vice versa) for consistent comparisons across firms.
How LIFO and FIFO differ (brief)
- FIFO assumes the oldest inventory is sold first. It typically results in lower COGS and higher ending inventory during inflationary periods, which raises reported gross margins and net income.
- LIFO assumes the newest inventory is sold first. It typically results in higher COGS and lower ending inventory during inflationary periods, reducing reported pre-tax earnings (and often taxes).
Simple example
If a company reports inventory of $1,200 using FIFO and $1,000 using LIFO, the LIFO reserve is:
LIFO reserve = $1,200 − $1,000 = $200
A positive reserve indicates FIFO inventory exceeds LIFO inventory (common in rising-price environments).
Accounting and analytical implications
- Tax impact: LIFO often reduces taxable income when prices are rising, because COGS is higher.
- Performance metrics: Changes in the LIFO reserve can affect adjusted EBITDA and adjusted EPS. Analysts commonly add back increases in the LIFO reserve when converting LIFO-reported figures to FIFO-based measures.
- Inflation indicator: Year-over-year changes in the LIFO reserve provide a rough proxy for inventory-related inflation, assuming product mix and inventory methods remain consistent.
- Terminology: Some accounting professionals prefer terms such as "revaluation to LIFO," "excess of FIFO over LIFO cost," or "LIFO allowance" instead of "reserve."
Benefits and limitations
Benefits:
- Enables apples-to-apples comparisons between companies using different inventory methods.
- Clarifies effects of inventory accounting on taxes, margins, and reported earnings.
Limitations:
- The reserve reflects only valuation differences, not operational performance.
- Changes can be influenced by shifts in inventory mix, costing assumptions, or one-time events, so interpretation requires context.
Bottom line
The LIFO reserve is a concise tool for reconciling LIFO and FIFO inventory valuations. Investors and analysts use it to normalize financial results, understand tax impacts, and assess how inventory valuation choices affect reported profitability.