Definition of LIFO Method
LIFO method, i.e. last in first out method, is one of the methods used to value the inventory of the business where the assumption of the this method is that the goods that are purchased/produced at last are sold firstly by the business organisation, and the items that are purchased/produced at first are assumed to remain idle in the store.
There are three inventory costing methods, and LIFO is one of them, and the other two are FIFO and weighted average methods. The last in, first-out method is based on the assumption that the items of goods purchased or manufactured at last are the ones that are sold by the business first. The LIFO method of valuation is mostly used by the companies with a relatively large level of inventories like retailers, etc., to take the tax benefit by including the costs of recent products produced/purchased at higher costs in the cost of goods sold. Therefore, the LIFO method of valuation is not allowed to be used in most of the countries.
Examples of LIFO
Suppose Mr. David started a Retail business of stationery on February 1st, 2019. He purchases identical registers from a wholesaler. The purchases for the month of February and March 2019 are as follows:
At the end of March, Mr. David finds out that the total registers sold by him are 500 units @30 each. So now we need to calculate the value of the cost of goods sold and closing inventory as of March 31st, 2019.
As the LIFO method of valuation is followed so inventory that is purchased at last will be considered to be sold first, so the registers purchased on March 20th should be included in cost first, then the registers purchased on March 5th and so on. Since the total units sold were 500 only, 50 units of inventory purchased on Feb 15th are to be taken in the cost of goods sold calculation. The remaining 150 units are considered in the closing inventory, along with the oldest inventory that was purchased on February 1st.
Following is the Tabular representation of the Calculation of Cost of goods sold and Closing inventory as of March 31st. 2019.
Value of Cost of goods sold:
Value of Closing inventory:
Therefore, the value of the cost of goods sold is $10,575, and value of closing inventory is $13,075, and the profit is $4,425(500*30-$10,575)
Impact of LIFO Inventory Valuation
When the LIFO method of inventory valuation is used, it means that the purchased products first remain in the store and become obsolete or very old. Also, the valuation under the LIFO method makes the valuation of inventory very low because the cost of old inventory items is obviously less than the cost of new items manufactured or purchased in this inflating market. Therefore the LIFO method is not considered to be realistic in today’s scenario because it shows that the older inventory remains idle and only the new products are sold, making the inventory valuation incorrect and very low.
Why the Use of LIFO?
The LIFO method of valuation is mostly used by the companies that have a relatively large level of inventories like retailers, etc., to take the tax benefit because due to the time of inflation, the cost of manufacturing or purchasing increases. The inventories are values at the earlier costs that are obviously low, and the high costs of recent inventories are included in the calculation of the cost of goods sold. Therefore, sale prices are matched with high costs to calculate profits, thereby decreasing the profits of the business, which ultimately results in the lower income tax payments.
LIFO vs FIFO
The difference between LIFO and FIFO are as follows:
- FIFO method, i.e. the first in first out method of inventory valuation, is based on the assumption that the items inventory that is purchased first are sold first, whereas, in the case of the LIFO method, the assumption is that the items of inventory that are mostly produced most recently are sold first by the business organisation.
- Under the FIFO method, the value of closing inventory is more, and the cost of goods sold is less as compared to the value of closing inventory and cost of goods sold valued as per the LIFO method because, under the FIFO method, the value of inventory includes the cost of items that are recently produced and cost of goods includes the cost incurred in production or purchase of old items and obviously at this time of inflation, costs of recently produced items are more than the costs of items that are produced earlier.
- The FIFO method is considered more realistic and logical than the LIFO method as the FIFO method doesn’t let the old inventory remain idle in the store.
Advantages of the LIFO method
The advantages of LIFO method are as follows:
- LIFO method is easy to implement and understand.
- It provides tax benefits to the business organisations by reporting less profits and deferring Income Tax payment in the future years.
- LIFO method provides the benefit of matching the current cost with the current revenues thereby reducing the profits included in the inventory.
Disadvantages of the LIFO method
The disadvantages of LIFO method are as follows:
- At the time of inflation the LIFO method results in hiding the actual profits of the business which can result in the negative impact about the business profitability position in the minds of the investor.
- The inventory figure is also understated at the time of inflation because the inventory includes the cost of products that are manufactured or purchased earlier and the cost of old products is less than the new ones.
- LIFO method is more complex when the prices of the products keep fluctuating.
Thus, LIFO Method is the method of valuation of inventory that assumes that the latest inventory items purchased or manufactured are sold first and the cost of goods sold includes the cost of recently purchased/ manufactured products and closing inventory includes cost of oldest products. LIFO method is not used by most of the countries as it doesn’t shows accurate results.
This is a guide to LIFO Method. Here we also discuss the definition and examples of LIFO method along with advantages and disadvantages. You may also have a look at the following articles to learn more –