How to Calculate LIFO Cost of Goods Sold

The Last-In, First-Out (LIFO) method is an inventory valuation technique businesses use to determine the cost of goods sold (COGS) and the value of their remaining inventory. This accounting method assumes that the most recently purchased or produced inventory items are the first ones sold. Understanding LIFO is important for businesses as it directly influences reported profitability and taxable income.

Understanding LIFO Inventory Fundamentals

The core principle of the LIFO inventory method is that the newest goods acquired are the first ones expensed when a sale occurs. This means the cost of items most recently added to inventory is assigned to the goods sold, while older inventory costs remain on the balance sheet as unsold inventory. This assumption often results in a higher cost of goods sold during periods of rising prices, as the most expensive inventory is matched against revenue.

To apply LIFO, businesses must understand several key data elements. Beginning inventory refers to the value and quantity of goods on hand at the start of an accounting period. Purchases are added to inventory, each recorded with its specific date, quantity, and unit cost. The total of beginning inventory and all purchases made during the period constitutes the goods available for sale, representing all items that could potentially be sold.

A fundamental concept in LIFO is that of inventory layers. Each distinct purchase made at a specific cost creates a new layer within the total inventory. For instance, if a business buys 100 units at $10, then later 150 units at $12, these represent two separate cost layers. When units are sold, the LIFO method dictates that these sales draw from the most recent layers first, ensuring that the costs assigned to goods sold reflect the latest acquisition prices.

Step-by-Step LIFO COGS Calculation

Calculating the Cost of Goods Sold (COGS) using the LIFO method begins by identifying the total goods available for sale during the accounting period. The objective is to determine which specific inventory costs, based on their purchase dates, should be allocated to the units sold.

With the LIFO assumption, businesses assign the cost of the most recently acquired units to the goods sold first. For example, if a company sold 50 units and its most recent purchase consisted of 30 units at $15 each, those 30 units would be expensed first. The remaining 20 units sold would then be costed from the next most recent purchase layer, perhaps 20 units at $12 each. This process continues, drawing from the newest layers backward, until the total quantity of units sold is accounted for.

The cost of each unit drawn from these recent layers is then multiplied by its quantity, and these individual costs are summed to arrive at the total LIFO COGS. For instance, using the previous example, the COGS for those 50 units would be (30 units $15) + (20 units $12), totaling $450 + $240 = $690.

Conversely, the ending inventory under LIFO is comprised of the oldest inventory layers that were not expensed as part of the cost of goods sold. These older costs remain on the balance sheet, representing the value of unsold goods. This means that while COGS reflects recent costs, the remaining inventory value may consist of significantly older, potentially lower, acquisition costs.

Maintaining Inventory Records for LIFO

Accurate application of the LIFO method relies heavily on meticulous inventory record-keeping. Businesses must track each inventory purchase with precision, noting the exact date of acquisition, the quantity of units received, and the specific cost per unit. This detailed tracking is essential because LIFO requires identifying and differentiating between various inventory layers based on their acquisition costs and dates.

Organized records of these distinct inventory layers are paramount for correctly applying the last-in, first-out assumption during COGS calculation. Without clear documentation of these layers, it becomes impractical to determine which specific costs should be allocated to goods sold under the LIFO flow assumption.

Businesses commonly utilize either manual record-keeping systems or specialized inventory management software to maintain this detailed data. These systems help ensure that necessary information—such as purchase order details, receiving dates, and unit costs—is readily available and accurately categorized.