LIFO

12/05/2021 1 By indiafreenotes

Last in, first out (LIFO) is a method used to account for inventory that records the most recently produced items as sold first. Under LIFO, the cost of the most recent products purchased (or produced) are the first to be expensed as cost of goods sold (COGS), which means the lower cost of older products will be reported as inventory.

Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first.

Two alternative methods of inventory-costing include first in, first out (FIFO), where the oldest inventory items are recorded as sold first, and the average cost method, which takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine COGS and ending inventory.

The last in, first out (LIFO) method is used to place an accounting value on inventory. The LIFO method operates under the assumption that the last item of inventory purchased is the first one sold. Picture a store shelf where a clerk adds items from the front, and customers also take their selections from the front; the remaining items of inventory that are located further from the front of the shelf are rarely picked, and so remain on the shelf – that is a LIFO scenario.

The trouble with the LIFO scenario is that it is rarely encountered in practice. If a company were to use the process flow embodied by LIFO, a significant part of its inventory would be very old, and likely obsolete. Nonetheless, a company does not actually have to experience the LIFO process flow in order to use the method to calculate its inventory valuation.

Example of the Last-in, First-out Method

Milagro Corporation decides to use the LIFO method for the month of March. The following table shows the various purchasing transactions for the company’s Elite Roasters product. The quantity purchased on March 1 actually reflects the inventory beginning balance.

Date
Purchased
Quantity
Purchased
Cost per
Unit
Units
Sold
Cost of
Layer #1
Cost of
Layer #2
Total
Cost
March 1 150 $210 95 (55 x $210) $11,550
March 7 100 235 110 (45 x $210) 9,450
March 11 200 250 180 (45 x $210) (20 x $250) 14,450
March 17 125 240 125 (45 x $210) (20 x $250) 14,450
March 25 80 260 120 (25 x $210) 5,250

The following bullet points describe the transactions noted in the preceding table:

  • March 1. Milagro has a beginning inventory balance of 150 units, and sells 95 of these units between March 1 and March 7. This leaves one inventory layer of 55 units at a cost of $210 each.
  • March 7. Milagro buys 100 additional units on March 7, and sells 110 units between March 7 and March 11. Under LIFO, we assume that the latest purchase was sold first, so there is still just one inventory layer, which has now been reduced to 45 units.
  • March 11. Milagro buys 200 additional units on March 11, and sells 180 units between March 11 and March 17, which creates a new inventory layer that is comprised of 20 units at a cost of $250. This new layer appears in the table in the “Cost of Layer #2” column.
  • March 17. Milagro buys 125 additional units on March 17, and sells 125 units between March 17 and March 25, so there is no change in the inventory layers.
  • March 25. Milagro buys 80 additional units on March 25, and sells 120 units between March 25 and the end of the month. Sales exceed purchases during this period, so the second inventory layer is eliminated, as well as part of the first layer. The result is an ending inventory balance of $5,250, which is derived from 25 units of ending inventory, multiplied by the $210 cost in the first layer that existed at the beginning of the month.