How to Calculate Cost of Goods Sold Using LIFO

The Cost of Goods Sold (COGS) represents the direct costs incurred by a business in producing or acquiring the goods it sells during a specific period. These costs include direct materials, direct labor, and manufacturing overhead directly tied to the creation or purchase of products. COGS is subtracted from revenue on a company’s income statement to determine gross profit, indicating how efficiently a business manages production costs. The Last-In, First-Out (LIFO) method is one of several acceptable accounting approaches used to calculate inventory costs and subsequently, COGS.

Understanding the LIFO Inventory Assumption

The Last-In, First-Out (LIFO) method operates on a specific inventory cost flow assumption. It dictates which costs are expensed first, not necessarily the physical movement of goods. Under LIFO, it is assumed that the most recently purchased or produced inventory items are the first ones sold. This contrasts with the actual physical flow for many businesses, where older inventory might be sold before newer stock.

This cost flow assumption is particularly relevant during periods of rising prices, as it matches the higher, more recent costs with current revenues. Using LIFO often results in a higher Cost of Goods Sold and a lower reported taxable income, which can lead to tax savings. LIFO’s impact lies in how it allocates costs to the income statement and values remaining inventory on the balance sheet.

The LIFO method is permitted under Generally Accepted Accounting Principles (GAAP) in the United States, but it is not allowed under International Financial Reporting Standards (IFRS). This distinction is important for multinational corporations or businesses with international operations. Companies electing to use LIFO for tax purposes must also use it for financial reporting, a requirement known as the LIFO conformity rule. This rule ensures consistency between a company’s tax reporting and its public financial statements.

Calculating Cost of Goods Sold with LIFO

Calculating Cost of Goods Sold (COGS) using the LIFO method involves systematically expensing the costs of the most recent inventory purchases first. This approach requires careful tracking of inventory purchases and their associated costs.

To illustrate, consider a business, “Gadget Co.,” that sells a single type of electronic gadget.
Beginning Inventory on January 1: 50 units at $100 each.
January 10 Purchase: 100 units at $110 each.
January 20 Purchase: 80 units at $120 each.
During January, Gadget Co. sells 180 units.

Under the LIFO method, the 180 units sold are assumed to come from the most recent purchases first. The 80 units purchased on January 20 at $120 each are expensed. This accounts for 80 of the 180 units sold, leaving 100 units remaining to be expensed. The remaining 100 units sold are assumed to come from the January 10 purchase of 100 units at $110 each.

Therefore, the Cost of Goods Sold for January would be calculated as follows:
(80 units from January 20 purchase × $120/unit) = $9,600
(100 units from January 10 purchase × $110/unit) = $11,000
Total COGS = $9,600 + $11,000 = $20,600.

The remaining inventory on the balance sheet would then consist of the oldest units: the 50 units from the beginning inventory at $100 each. This leads to an ending inventory value of $5,000 (50 units × $100/unit).

Businesses must maintain detailed records of all inventory purchases and their costs to accurately apply the LIFO method.

Managing LIFO Inventory Layers

LIFO inventory layers refer to the distinct cost groups created each time a new purchase of inventory is made at a different price. Under the LIFO assumption, when goods are sold, these layers are consumed starting from the most recent purchase layer, moving backward through older layers as needed. The oldest costs are the ones that remain in the ending inventory.

The existence and management of these layers are important for accurate LIFO COGS calculations, especially when inventory levels fluctuate. If a company sells more units than it purchases in a given period, it may “dip into” or “liquidate” older LIFO layers. This event, known as LIFO liquidation, occurs when current sales exceed current purchases, forcing the company to use costs from earlier, often lower-cost, inventory layers.

When older, lower-cost layers are liquidated, the Cost of Goods Sold decreases, leading to a higher reported gross profit and taxable income. This can result in an unexpected tax burden for the company, as the tax benefit normally associated with LIFO in inflationary periods is reversed. Companies generally aim to avoid LIFO liquidation to maintain their tax advantages and prevent distortion of reported profits. Maintaining adequate records of these layers is important for businesses using LIFO, as the IRS may scrutinize such records.