LIFO, which stands for "last-in-first-out," is an inventory valuation method which assumes that the last items placed in inventory are the first sold during an accounting year. Thus, the inventory at the end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the end. LIFO is one method used to determine Cost of Goods Sold for a business. LIFO accounting is only used in the United States.
Electing to Use LIFO Method
The IRS allows businesses to change from FIFO to LIFO inventory accounting, but it requires an application Form 970 in order to do this. The IRS says:
Section 472(a) of the Internal Revenue Code allows a taxpayer to elect the LIFO inventory method. The use of LIFO, however, must be in accordance with the regulations, must be applied on a consistent basis, and must clearly reflect income. In addition, inventories on LIFO must not be valued lower than cost.
In addition, the IRS will not allow a return to FIFO once LIFO has been selected.
Before you decide to use LIFO accounting, talk to your accounting professional and tax advisor.
Here is how inventory cost is calculated using the LIFO method:
Assume a product is made in three batches during the year. The costs and quantity of each batch are:
- Batch 1: Quantity 2,000 pieces, Cost to produce $8000
- Batch 2: Quantity 1500 pieces, Cost to produce $7000
- Batch 3: Quantity 1700 pieces, Cost to produce $7700
- Total produced: 5,200 pieces. Total cost $22,700. Average cost to produce one piece: $4.37.
Next, you must calculate the unit costs for each batch produced.
- Batch 1: $8000/2000 = $4
- Batch 2: $7000/1500 = $4.67
- Batch 3: $7700/1700 = $4.53
Let's say you sold 4000 units during the year, out of the 5200 produced. To determine the cost of units sold, under LIFO accounting, you start with the assumption that you have sold the most recent (last items) produced first, and work backwards.
So, of the 4000 units sold, using LIFO
You assume that batch 3 items were sold first. So, The first 1700 units sold from the last batch cost $4.53 per unit. That's a total of $7701.
- The next 1500 units sold from the second batch cost $4.67 per unit, for a total of $7005.
- And the last 800 units sold from the first batch cost $4 each, for a total of $3200.
The total cost of the 4000 items sold is $17,906.
The cost of the remaining 1200 units from the first batch is $4 each. These units will start off the next year.
This calculation is not exactly what happened, because it may not be possible to determine which items from which batch were sold in which order. It's just a way to get a calculation.
Other inventory costing methods
Instead of using LIFO, some businesses use one of these other inventory costing methods:
- Specific identification is used when specific items can be identified. For example, the cost of antiques or collectibles, fine jewelry or furs, can be determined.
- FIFO costing ("last in, first out"), which considers the first produced products as being those sold first. In this case, you would assume that Batch 1 items would be sold first, then Batch 2 items, then the remaining 500 items from Batch 3. The total cost of 4000 items sold under FIFO accounting would be $17,270.
- Average cost is just the overall average of the cost of all items. The total cost of 4000 items sold at an average cost of $4.37 would be $17,461.53.
One reason for valuing inventory is to determine its value for inventory financing purposes.