LIFO (Last-In-First-Out) Inventory Cost Method
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. The default inventory cost method is called FIFO (First In, First Out), but your business can elect LIFO costing. LIFO accounting is only used in the United States.
Your business inventory is a valuable asset in your accounting system. And costs associated with making, buying, maintaining, and shipping inventory are legitimate business expenses that can be deducted from your business tax return. So it's important to keep track of inventory costs
The inventory process at the end of a year is used to determine cost of goods sold (COGS) for a business, to be included on the business tax return. This process is for tax purposes, and it is used for both periodic and perpetual inventory systems. The inventory calculation for COGS includes:
- counting of inventory at that year-end date,
- gathering information about inventory at the beginning of the year and
- including costs of inventory (purchases and materials and other expenses). This is the point where the LIFO inventory costing method is used.
An Explanation of LIFO Inventory Costing
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 backward.
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.
Electing to Use LIFO Method
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 business tax professional.