What is the LIFO method?

With the LIFO method, goods that were last added to inventory are withdrawn first. The LIFO principle can also play a role in accounting for a company’s assets. [TOC]

What is LIFO?

The LIFO principle is a procedure from inventory management which states that goods that were last added to an inventory are withdrawn first. LIFO stands for “last in, first out”. Since the LIFO method also plays a role in the valuation and taxation of goods, it is particularly important for the stock control systems of online stores. Companies should also carefully develop systems for supply chain management and their distribution channels. Although LIFO can be used by companies that do not have a warehouse strategy, this is usually not recommended.

How does the LIFO method work?

To get a better idea of how the LIFO method works, let’s look at an example from everyday life. Imagine you’ve just bought a new shirt and want to store it in your closet. You neatly fold it and place it on top of a pile with your other shirts. The next day, you take out your new shirt from the top of the stack, and the rest of the “stock” remains untouched. This same principle is also used in merchandise management: New items are positioned in such a way that they can be retrieved first. The opposite of LIFO is the FIFO method (first in, first out).

What do you need to consider before implementing the LIFO method?

Before implementing the LIFO method, you first have to consider the nature of the goods you are dealing with. LIFO is not recommended for products that have an expiration date, can be damaged by prolonged storage, lose value over a longer period, or are tied to a current trend. On the other hand, if the stored goods are durable and don’t need to be distributed in any particular order, LIFO is relatively easy to implement. Goods can be stored in a storeroom, in open spaces or pits, in high racks or permanently bolted to the wall. However, the LIFO method can make it difficult to keep track of your inventory.

What are the advantages of the LIFO method?

If your warehouse and the nature of your goods are compatible with the last-in, first-out method, the system can provide you with several advantages. Due to its simplicity, new employees can stock the warehouse without any special training needed. This shortens organizational times considerably and reduces the number of employees needed to remove and stock goods. Distances are shorter, and with the optimization of storage space, storage costs can also be reduced. With LIFO, you can store older goods long term, and you don’t need to invest in an expensive, free-standing shelving system.

How is inventory evaluated with LIFO?

LIFO doesn’t just play a role in warehouse management. The LIFO method can also be used to value your company’s assets. It is used both in commercial law and in tax law.

LIFO in commercial and tax law

Just like its counterpart FIFO, LIFO accounting has been part of the U.S. tax code since 1939 and complies with the U.S. generally accepted accounting principles (GAAP). Although it is allowed in the U.S., it is prohibited under IFRS (International Financial Reporting Standards). With the LIFO method, companies must subtract costs from their gross revenues to determine taxable profit. The inflation on items is included in the cost of the sold goods, which can lead to a decrease of taxable income.

What are the LIFO methods?

LIFO uses two different methods to carry out calculations: the permanent method and the periodic method. In both cases, the lowest value principle applies. This means that assets may never be recorded in the balance sheet at a value that is too high. If lower values can be determined, these must be used instead. All values on the reporting date are compared with current market values of a commodity and the lower value is applied.

Dollar-value LIFO

Dollar-value LIFO is a variation of the LIFO method that tracks changes in inventory values based on changes in prices, rather than the physical units of inventory. If the prices of goods increase, the dollar value of the inventory will also increase, even if the quantity remains the same.

The perpetual LIFO principle

In the perpetual LIFO method, additions and disposals are recorded continuously throughout the entire period. Although this LIFO principle is very accurate, it is time-consuming, which is why it is rarely used in practice. Here, we will use an example to show how the perpetual method of LIFO works.

Let’s imagine a candy company that needs to purchase sugar for its production. A simplified version of their annual balance sheet looks like this:

The first delivery took place on May 1. Using LIFO, the supply from February 1 is taken first. However, since additional product was needed to fill the order, an additional 10 lbs was taken from the initial supply. This means that 100 lbs are calculated at the purchase price of $1 and 10 lbs at the price of $2. This results in a total value of $120. The second goods issue uses the July 1 supply, where the cost was $4. However, since more than the supplied 150 lbs was needed, another 50 lbs was used from the initial stock. The cost of sold goods (COGS) for the second delivery amounts to $700.

Since the supplies were completely used up, the sugar that is left at the end comes entirely from the initial supply that was recorded in January. To calculate the ending inventory, multiply the remaining 140 lbs by the initial value of $2, giving you $280. To determine material costs, the two goods issues are added together: $120 + $700 = $820.

The periodic LIFO principle

The periodic LIFO method works a little differently. Here, only the ending inventory is recorded and multiplied by the price of the opening inventory. This simplifies the calculation. Using the LIFO approach, it is assumed that the stock that was last delivered has already left the warehouse. Taking the data from the example above, the calculation using the periodic LIFO principle would look like this:

The closing inventory is calculated according to the opening inventory. In this case, this means that the 140 lbs are multiplied by $2, which equals $280. To calculate the cost of materials, use the following formula:

Opening inventory + goods receipts - closing inventory

In this case, this means: (200 lbs x $2) + (100 lbs x $1) + (150 lbs x $4) - $280 = $820. To determine the value for individual issues, add all the good issues together, then take the remaining inventory and divide it by the sum of the good issues. In this example, this would be $820 divided by 310 lbs This results in approximately $2.65/lb.