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.
Inventory Valuation Methods
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. So it's important to keep track of inventory costs. To value your inventory you need a way to identify the items in your inventory and assigning them a value.
The inventory process at the end of a year determines cost of goods sold (COGS) for a business, to be included on your business tax return. Cost of goods sold is deducted from your gross receipts (before expenses) to figure your gross profit for the year.
The calculation for COGS is:
- Counting of inventory at the beginning of a year
- Adding purchases, cost of labor, and other costs, and
- Subtracting inventory at the end of the year.
LIFO vs. FIFO Inventory Costing.
FIFO (first-in, first-out) and LIFO (last-in, first-out) are the two common ways to value inventory. FIFO assumes that the items you bought or produced first are the first items you sell, consume, or dispose of.
FIFO inventory costing is the default method; if you want to use LIFO, you must elect it.
LIFO is first-in, first-out inventory costing that assumes the items you purchased or produced last are the first items you sell, consume, or dispose of first.
In normal times of rising prices, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher.
How LIFO Inventory Costing Works
The IRS admits that the rules for using the LIFO method are complex. Several common rules are:
- Dollar-value, which involves pooling items into classes
- Simplified dollar-value, group
You can also value inventory at cost or retail with LIFO.
A Simple Example of LIFO:
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 $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. The average cost to produce one piece: $4.37.
Next, 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. Thus, 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.
Electing to Use the LIFO Method
Once you adopt the LIFO method, you can't go back to FIFO unless you get approval to change from the IRS.
The IRS allows businesses to change from FIFO to LIFO inventory accounting, but it requires an application Form 970 in order to do this. You must 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 inventory price index computation (IPIC) method.