Costco’s Recent Earnings Shows LIFO Accounting Helps Retailers As Inflation Abates

Many retailers have used the LIFO (last in, first out) accounting method to manage their inventory reporting. The methods assumes that the last unit to arrive in inventory (the most recent) is sold first. On the other hand, the FIFO method (first in, first out) assumes the oldest unit of inventory is sold first.

In the second quarter 2023, that Costco reported on February 12, 2023, no LIFO charge was applied as compared to a LIFO charge of $71 million in the comparable quarter in fiscal 2022. According to Costco’s CFO
CFO
, Richard Galanti, his company sees some inflationary relief.

LIFO companies – and there are many retailers among them, from Macy’s to the domestic portion of Walmart
WMT
– use the U.S. generally accepted accounting principles (GAAP) and this specific inventory reporting method to lower their taxable income. However, to do this they must use it for calculating results for financial accounting purposes as well, even though it can hit reported earnings.

“In an inflationary environment, as costs go up, Last In, First Out, your cost of goods sold are going to go up and that is going to generate less earnings, basically”. said Ron Graziano, an accounting and tax strategist at Credit Suisse Group
CS
who was quoted by the CFO Journal. So, that is a bad thing from the perspective of booking profits in a financial statement but a good thing for taxable income because taxable income is less in that period.

It is true that rising inflation means that companies generally continue to have higher LIFO charges. It depends on how quickly companies can turn merchandise over.

Costco is a textbook example of these dynamics. Management saw a slight decline in the rate of inflation, according to Mr. Galanti. In the company’s fourth quarter which end last August, management estimated that the inflation rate was 8%. In the first quarter it was about 7% and dropped again in the 2^nd quarter to 5% or 6%.

Commodity prices are starting to fall, and the company is seeing relief on chicken, butter, bacon and nuts. One hopes that it will continue to decline so that the LIFO charges will be reduced. It certainly will help the quarterly report of the Costco. In the quarter ended February 12, net sales increased +6.5% to $55.5 billion from $51.9 billion. Inventory was down to about $16 billion. In contrast, Kroger
KR
took a LIFO charge of $626 million for fiscal 2022 and expects a LIFO charge of $300 to $350 million this year, which shows a reduction of inflationary merchandise by about 50%. Other grocery retailers report LIFO charge increases as well.

What is LIFO?

1. The First Out (LIFO) method assumes that the last unit to arrive in inventory or more recent is sold first.

2. The First-In, First Out (FIFO) method assumes that the oldest unit of inventory is the item sold first.

3. LIFO is not realistic as an inventory reporting tool for many companies because they would not leave their older inventory sitting idle in stock (especially when the inventory is needed in production processes or the good themselves are perishables or items with very short shelf lives).

4. FIFO is the most logical choice since companies typically use their oldest inventory in the production of their goods.

5. Deciding between these two inventory methods should be carefully considered; there are implications on a company’s financial statement as this decision impacts the value of inventory, cost of goods sold, and net profit.

About 400 companies use LIFO. Among the largest are automobile, petroleum, and pharmaceutical retailers. As indicated elsewhere in this report, Macy’s, Amazon
AMZN
and other department stores are on LIFO accounting as well. However, any retailer who has international dealings cannot be on LIFO. While Home Depot is on LIFO, Lowe’s is not.

POSTSCRIPT: It will be interesting to see how retailers will report their merchandise content. The current environment suggests that we will see a further drop in inflationary pressures. That will likely encourage more retailers to adopt the LIFO valuation. It will certainly determine the profitability of some retailers.