The last in, first out method (LIFO) is the reverse of the FIFO method. Under the LIFO method, the earliest costs are assigned to ending inventory, and the costs of the most recent purchases are assigned to the cost of goods sold. The LIFO method assumes that the latest goods purchased are to be sold at first.
Let’s see the solution to our problem table-I under the LIFO method;
| Date | Units | Unit Cost ($) | Total Cost ($) |
|---|---|---|---|
| Aug. 8 | 300 | 24 | 7,200 |
| Apr. 15 | 400 | 22 | 8,800 |
| Jan. 1 | 200 | 20 | 4,000 |
| Cost of ending inventory | 20.000 |
So the cost of goods sold is $28,000 (48000-2000).
Features of the LIFO method
- In the calculation of costs of ending inventory, the earliest unit costs are assigned to the units not sold, those in ending inventory.
- In the calculation of the cost of goods sold, the more recent unit costs are assigned to the units sold, those in the cost of goods sold expense.
Advantages of LIFO
- Matches more recent costs with current revenue better than FIFO or weighted average.
- Yields the lowest income, thus the lowest income tax obligation during periods of rising prices.
Disadvantages of LIFO
- It does not produce an ending inventory amount that contains costs as recent as those included under FIFO or weighted average.
- The process is much more complicated.
Objectives of the LIFO inventory system are;
- The major objective of the LIFO method is to change the cost of goods sold with the most recent cost incurred.
- Adjust the financial statements for inflation.
- To obtain a better matching of current revenues with current costs in times of inflation.
Effects of LIFO in Income and Inventory
- The Last In, First Out method assumes the items you have most recently purchased or produced are the first items you sold, consumed, or otherwise disposed of. Under LIFO inventory, sold items are assumed to be the items most recently purchased or produced.
- Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year.
- Inventory and cost of goods sold are interdependent. As a result, if the LIFO method is used in a rising-price and increasing-inventory environment, more of the higher-cost goods (last ones in) will be accounted for in COGS.
- Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year.
- During periods of inflation, the use of LIFO will result in the highest estimate of the cost of goods sold among the three approaches and the lowest net income. Since prices generally rise over time because of inflation, this method records the sale of the most expensive inventory first and thereby decreasing profit and reducing taxes. However, this method rarely reflects the physical flow of indistinguishable items.
- LIFO valuation is permitted in the belief that an ongoing business does not realize an economic profit solely from inflation. When prices are increasing, they must replace inventory currently being sold with higher-priced goods.
- LIFO better matches current costs against current revenue. It also defers paying taxes on phantom income arising solely from inflation.
- LIFO is attractive to businesses in that it delays a major detrimental effect of inflation, namely higher taxes. However, in the very long run, both methods converge.
Effects of the LIFO Inventory Cost Methods on Earnings During Inflation
Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs.
The inventory, however, is valued on the basis of the cost of materials bought earlier in the year.
During periods of inflation, the use of LIFO will result in the highest estimate of the cost of goods sold among the three approaches and the lowest net income.
Since prices generally rise over time because of inflation, this method records the sale of the most expensive inventory first, decreasing profit and reducing taxes.
However, this method rarely reflects the physical flow of indistinguishable items.
LIFO valuation is permitted in the belief that an ongoing business does not realize an economic profit solely from inflation. When prices are increasing, they must replace inventory currently being sold with higher-priced goods. LIFO better matches current costs against current revenue.
It also defers paying taxes on phantom income arising solely from inflation. LIFO is attractive to businesses in that it delays a major detrimental effect of inflation, namely higher taxes.
However, in the very long run, both methods converge.
LIFO Method of Pricing Materials
This method assumes that the last unit entering the inventory is sold first. The older inventory, therefore, is left over at the end of The accounting period.
Advantages:
- Issues are charged at the current price, which is more appropriate.
- Profit is realistic.
- Since issues are charged at actual cost, no adjustment for profit or loss is necessary.
Disadvantages:
- Stock value does not represent the current market price.
- Unfair comparison of job cost when pricing changes too frequently.
- Like FIFO, this method also involves too many calculations if frequent price changes occur and purchases are made in small lots.
However, the method is useful for materials used less frequently and under inflationary conditions.
