Inventory cost accounting using the LIFO method.
The acronym LIFO stands for Last In First Out.
LIFO is a US-based accounting fiction in cost accounting, mainly for tax reasons, that is
a major determinant of Cost Of Goods Sold and Gross Profit.
When I say “US-based accounting fiction”, I mean that LIFO is an acceptable method under
US Generally Accepted Accounting Principles (US GAAP), while it is prohibited under International
Financial Reporting Standards (IFRS).
The comment “mainly for tax reasons” will become clear to you when seeing the numerical
results of the example we go through.
Let’s work through an example of LIFO.
We will do the inventory accounting for a hypothetical company called Toy Giraffe Inc.
As the name suggests, this is a company buying and selling toy giraffes.
In the first quarter of the year, Toy Giraffe Inc is building up its inventory.
In January, they buy 100 units (packed in 2 boxes of 50 units each) at $5 per unit.
In February, 200 units (4 boxes of 50 units) at $6 per unit.
In March, another 100 units (2 boxes of 50 units) at $7 per unit.
As you see, the cost per unit for toy giraffes is going up fast.
The Q1 ending inventory is 400 units at a total purchase price of $2400, so on average
$6 per unit.
In the warehouse, the company does not specifically identify the boxes, they just stack them on
a big pile.
For cost accounting and inventory valuation purposes, the company does keep track of the
timing of the buys and the unit cost in “layers”.
Then we go to April.
The ending inventory of Q1 is the beginning inventory of Q2.
The first box of toy giraffes (50 units) is sold in April.
The ending inventory is 7 boxes of 50 units each, 350 units in total.
For inventory valuation as well as determining Cost Of Goods Sold, it is important to determine
what is the cost per unit for this specific box.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first, so we
assume that the box sold originated from the March buy.
What remains in inventory at the end of April is the full 100 units from the January buy,
the full 200 units from the February buy,
and the remaining 50 units from the March buy.
In total, 350 units with a total purchase price of $2050, so on average $5.86 per unit.
Under LIFO, the average cost per unit in inventory goes down in this example.
If we prepare the income statement for April, revenue is 50 units times $10 = $500, Cost
Of Goods Sold (or COGS) is 50 units times $7 = $350, and Gross Profit is $150.
Out of the March buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
Onward to May.
The ending inventory of April is the beginning inventory of May.
Two boxes of toy giraffes are sold in May.
The ending inventory is 5 boxes of 50 units each, 250 units in total.
We once again apply LIFO, Last In First Out,
and assume that the newest inventory gets sold first.
What remains in inventory at the end of May is the full 100 units from the January buy,
150 units from the February buy, and no units from the March buy.
In total, 250 units with a total purchase price of $1400, so on average $5.60 per unit.
If we prepare the income statement for May, revenue is 100 units times $10 = $1000, Cost
Of Goods Sold (or COGS) is 50 units times $7 = $350 plus 50 units times $6 = $300, and
Gross Profit is $350.
Out of the remaining March buy that was part of the beginning inventory, we took all 50
units to COGS, and we took 50 units from the February buy into COGS.
The remaining 150 units from the February buy go to the ending inventory.
Onward to June.
The ending inventory of May is the beginning inventory of June.
Four boxes of toy giraffes are sold, sales are really picking up pace.
The ending inventory is just 1 box of 50 units.
We once again apply LIFO, Last In First Out,
and assume that the newest inventory gets sold first.
What remains in inventory at the end of June is just 50 units from the January buy: 50
units of $5 each, $250 in total.
If we prepare the income statement for June, revenue is 200 units times $10 = $2000, Cost
Of Goods Sold (or COGS) is 150 units times $6 = $900, plus 50 units times $5 = $250,
so total COGS of $1150, and therefore a Gross Profit of $850.
Out of the remaining February buy that was part of the beginning inventory, we took all
150 units to COGS, and we took 50 units from the January buy into COGS.
The remaining 50 units from the January buy go to the ending inventory.
Summary and conclusion.
Last In First Out, is a US-based accounting fiction in cost accounting, mainly for tax
reasons, that is a major determinant of Cost Of Goods Sold and Gross Profit.
If cost per unit goes up over time, and selling price stays flat, you make the lowest profit
per unit in the earlier periods, as you “sell the newest inventory first”.
This is what the comment “mainly for tax reasons” relates to.
The lower the inventory value, and the higher the Cost Of Goods Sold, the lower the taxable
income you generate in the period.
The lower your taxable income, the lower the tax charge.
Thank you for watching!
The related videos on inventory accounting using the FIFO method, and the comparison
between FIFO and LIFO could also be useful for you.
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