Last In, First Out Inventory (LIFO) Method Explained
When businesses that sell products do their income taxes, they must account for the value of these products. There are several IRS-approved ways to value your inventory.
Last in, first out (LIFO) is one of these inventory valuation methods. It assumes that the last items placed in inventory are the first sold during an accounting year.
Inventory Valuation Methods
Your business inventory, which includes your stock of products, parts, and materials, is a valuable asset. And costs associated with making, buying, maintaining, and shipping inventory are important business expenses. To value your inventory, you need a way to identify the items within it and assign them a value.
Correctly valuing inventory is important for business tax purposes because it's the basis of cost of goods sold (COGS). Making sure that COGS includes all inventory costs means you are maximizing your deductions and minimizing your business tax bill.
Calculating Cost of Goods Sold
The inventory process at the end of a year determines cost of goods sold (COGS) for a business, which will be included on your business tax return. COGS is deducted from your gross receipts (before expenses) to figure your gross profit for the year.
The process for calculating COGS is:
- Counting inventory at the beginning of a year
- Adding purchases, cost of labor, and other costs
- Subtracting inventory at the end of the year.
How LIFO Inventory Costing Works
When you do the COGS calculation, you have several options for determining the cost of your inventory. The three common ways to value inventory are:
- Specific Identification: This is used for types of inventory when you can identify and match the actual cost to the items (for example, a car using the Vehicle ID Number)
- LIFO: This method assumes that the items you bought or produced LAST are the first items you sell, consume, or dispose of
- First In, First Out (FIFO): With the FIFO method, you as a business owner assume the items you purchased or produced first are the first items you sell, consume, or dispose of.
If you select the LIFO cost method, you then may group items to make it easier to count them, using one of the IRS-approved rules. Two of these rules for valuing LIFO are:
- The dollar-value method, in which goods are products are grouped into classes, depending on the kinds of goods or products
- The simplified dollar-value method, with multiple inventory classes in general categories
Your small business may use the simplified method if the business had average annual gross receipts of $5 million or less for the previous three tax years.
An Example of LIFO Calculation
Assume a product is made in three batches during the year. The costs and quantity of each batch (in order of when they are produced) are as follows:
- Batch 1: Quantity 2,000 pieces, cost to produce $8,000
- Batch 2: Quantity 1,500 pieces, cost to produce $7,000
- Batch 3: Quantity 1,700 pieces, cost to produce $7,700
Total produced: 5,200 pieces. Total cost: $22,700. The average cost to produce one piece: $4.37.
Next, calculate the unit costs for each batch produced.
- Batch 1: $8,000/2,000 = $4
- Batch 2: $7,000/1,500 = $4.67
- Batch 3: $7,700/1,700 = $4.53
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 backward.
Let's say 4,000 units were sold during the year. Using LIFO, you assume that Batch 3 items were sold first. Thus, the first 1,700 units sold from the last batch cost $4.53 per unit. That's a total of $7,701.
- The next 1,500 units sold from Batch 2 cost $4.67 per unit, for a total of $7,005.
- And the last 800 units sold from Batch 1 cost $4 each, for a total of $3,200.
- 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 for a total of $4,800. These units will start off the next year.
This calculation is hypothetical and inexact, because it may not be possible to determine which items from which batch were sold in which order. It's just an example for how to get a calculation.
LIFO vs. FIFO
FIFO assumes that the items from the first batch will be sold first. Using the example above and assuming that 4,000 units were sold:
All 2,000 of Batch 1 items are counted at $4.00 each, total $8,000.
Then, 1,500 of Batch 2 items are counted at $4.67 each, total $7,000.
Finally, 500 of Batch 3 items are counted at $4.53 each, total $2,265.
- The total cost under FIFO is $17,265.
- The total inventory cost under LIFO was $17,906.
The cost of the remaining items under FIFO is $5,436; under LIFO the cost is $4,800.
In normal times of rising prices, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the COGS will be lower and the closing inventory will be higher.
Electing to Use the LIFO Method
FIFO inventory costing is the default method; if you want to use LIFO, you must elect it. Also, once you adopt the LIFO method, you can't go back to FIFO unless you get approval to change from the IRS.
If you want to change to LIFO, you must complete and file an application on Form 970. File the form with your tax return for the year in which you first use LIFO.
To complete the election application, you will need to:
- Specify the goods to which the LIFO method will apply,
- Identify and describe the inventory method(s) you used in the prior year to value these goods, and
- Explain what goods the LIFO method will NOT be used for.
You also must provide detailed information on the costing method or methods you'll be using with LIFO (the specific goods method, dollar-value method, or another approved method).
- LIFO (Last-In, First-Out) is one method of inventory used to determine the cost of inventory for the cost of goods sold calculation.
- LIFO valuation considers the last items in inventory are sold first, as opposed to LIFO, which considers the first inventory items being sold first.
- If you want to use LIFO, you must elect this method, using IRS Form 970.
- Before you decide to use LIFO, talk to your business tax professional to make sure it's allowed and that you file the election correctly.