How to Do LIFO for Inventory Valuation

Last-In, First-Out (LIFO) is an inventory costing method that assumes the most recently acquired inventory items are the first ones sold. This approach impacts how a company’s financial statements reflect the cost of goods sold and the value of remaining inventory. LIFO is a cost flow assumption, meaning it dictates how costs are matched against revenues, rather than reflecting the actual physical movement of goods. Companies often choose LIFO for potential tax advantages, especially during periods of rising prices, by recognizing higher costs sooner. The method’s application requires careful tracking of inventory costs as they are incurred.

Understanding LIFO Layers

The concept of LIFO layers, or LIFO pools, is fundamental to applying the Last-In, First-Out inventory method. Under LIFO, inventory is accounted for in distinct layers, each representing a specific quantity of inventory acquired at a particular cost. A new layer is formed each time a company purchases or produces inventory if the current inventory level exceeds previous levels. These layers are effectively records of inventory units acquired at specific historical costs.

For example, if a company buys 100 units at $10 each, that forms the first layer. A subsequent purchase of 50 units at $12 each would create a second, separate layer. These layers are maintained over time, serving as the building blocks for calculating inventory costs. New layers are added on top of existing ones when inventory levels increase, reflecting the cost of the most recent acquisitions.

When goods are sold, LIFO assumes units are drawn from the most recently established layers first. This means the cost of goods sold will be based on the cost of the newest inventory. If the quantity sold exceeds the units in the most recent layer, units from the next most recent layer are assumed to be sold, and so on. This process continues until the total number of units sold has been accounted for.

The remaining inventory consists of units from the oldest, earliest layers. These older layers are preserved as long as the inventory quantity does not fall below the level at which those layers were established. This directly influences both the cost of goods sold and the reported value of ending inventory on the balance sheet.

Calculating Cost of Goods Sold and Ending Inventory

Applying the LIFO method to calculate the Cost of Goods Sold (COGS) and ending inventory involves a direct application of the layer concept. When a sale occurs, the cost assigned to those units is taken from the most recent inventory layers, working backward from the newest acquisitions. This directly impacts COGS, as higher costs from recent purchases are recognized first, which can lead to higher COGS during periods of rising prices. Conversely, the ending inventory valuation will consist of the costs from the oldest remaining layers.

Consider a company, “Gadget Co.,” that sells a single product. At the beginning of January, Gadget Co. has 50 units in inventory, purchased at $10 per unit. This forms its base layer. On January 10, Gadget Co. purchases 100 units at $12 per unit, creating a new layer. On January 20, another 75 units are purchased at $14 per unit, forming a third layer.

Assume Gadget Co. sells 180 units during January. To calculate COGS under LIFO, the 180 units sold are assumed to come from the most recent layers first. All 75 units from the January 20 purchase (at $14 each) are considered sold, contributing $1,050 (75 units $14/unit) to COGS. The remaining 105 units (180 total sold – 75 from latest layer) are assumed to come from the January 10 purchase. These 100 units contribute $1,200 (100 units $12/unit) to COGS.

The remaining 5 units needed (180 – 75 – 100 = 5) are assumed to come from the beginning inventory layer of 50 units at $10 each. These 5 units contribute $50 (5 units $10/unit) to COGS. Therefore, the total COGS for January is $1,050 + $1,200 + $50, equaling $2,300.

To determine the ending inventory, the remaining units are identified from the oldest layers that were not sold. In this example, 45 units remain from the beginning inventory layer (50 units – 5 units sold). Thus, the ending inventory value is 45 units $10/unit, totaling $450.

Managing the LIFO Reserve

The LIFO Reserve is an accounting concept used to reconcile the difference between inventory cost calculated under the LIFO method and what it would have been under another method, typically First-In, First-Out (FIFO) or average cost. It functions as a contra-asset account, reducing the reported value of inventory on the balance sheet. Companies often maintain a LIFO reserve to provide financial statement users with a clearer picture of inventory value, as many international accounting standards do not permit LIFO.

The LIFO reserve effectively bridges the gap between two different inventory costing assumptions. It is calculated as the difference between the inventory value under FIFO (or average cost) and the inventory value under LIFO. For example, if inventory under FIFO is $100,000 and under LIFO is $80,000, the LIFO reserve would be $20,000. This amount is reported in financial statements, often in the footnotes, to allow for comparability with companies using other inventory methods.

Each accounting period, the LIFO reserve is adjusted to reflect changes in this difference. This adjustment, known as the “LIFO reserve adjustment,” directly impacts the Cost of Goods Sold. An increase in the LIFO reserve results in an increase to COGS, while a decrease reduces COGS. For instance, if the LIFO reserve increased from $20,000 to $25,000, the additional $5,000 would be added to COGS.

Handling LIFO Liquidation

LIFO liquidation occurs when a company sells more inventory units than it purchases during a period, reducing its overall inventory levels. Under the LIFO cost flow assumption, this means that not only are the most recent inventory layers sold, but older, lower-cost inventory layers are also “liquidated” or drawn down. This situation often arises due to decreased demand, supply chain disruptions, or strategic inventory reductions.

The financial implications of LIFO liquidation can be substantial, particularly during periods of inflation or rising inventory costs. When older, lower-cost layers are sold, they are recognized as part of the Cost of Goods Sold. This results in a lower COGS than if only current, higher-cost inventory had been sold. Consequently, reported gross profit and taxable income will be higher because older, cheaper costs are matched against current revenues.

For example, if a company had a LIFO layer of 100 units at $5 from five years ago, and current inventory costs are $15 per unit, liquidating those 100 units would result in a COGS of $500 for those items. If new inventory at $15 had been sold instead, the COGS would have been $1,500. This $1,000 difference directly increases taxable income. The Internal Revenue Service (IRS) scrutinizes LIFO liquidation because it can artificially inflate profits and tax liabilities for the period in which it occurs. Companies must carefully track their inventory layers to identify and account for any liquidation events.