How to Perform a LIFO Calculation for Inventory
Learn the procedural steps for applying the LIFO inventory method to accurately determine Cost of Goods Sold and ending inventory valuations.
The Last-In, First-Out (LIFO) inventory costing method assumes that the most recently acquired inventory is the first to be sold. This approach affects the calculation of the Cost of Goods Sold (COGS) and the value of remaining inventory. When costs are rising, LIFO matches the most recent, higher costs against current revenues, resulting in a higher reported COGS. This leads to lower reported profits and a lower valuation for ending inventory.
LIFO is recognized under U.S. Generally Accepted Accounting Principles (GAAP) and can impact a company’s income tax liability. By reporting a higher COGS during inflationary periods, a business can reduce its taxable income and defer tax payments. It is important to note that LIFO is a cost flow assumption for accounting and does not need to match the actual physical flow of goods.
Information Required for LIFO Calculation
To perform a LIFO calculation, a business must keep detailed records of its inventory transactions. A log of all inventory purchases is needed, which must include the date of each acquisition, the quantity of units received, and the cost per unit. This cost-layering information is necessary to assign the correct costs to sold goods.
A complete record of inventory sales is also required. This sales log must track the date of each sale and the number of units sold. While the selling price is used to calculate revenue, it is not part of the LIFO calculation, which only uses inventory cost.
The Periodic LIFO Calculation Method
The periodic LIFO method calculates inventory costs at the end of an accounting period, like a month or year. The process begins by determining the total cost of goods available for sale by adding the beginning inventory’s value to the total cost of all inventory purchased. For example, if a company starts with 100 units at $10 each, and purchases 200 units at $12 and 150 units at $15, its cost of goods available for sale is $5,950 for 450 units.
Next, a physical count of the inventory remaining at the period’s end is conducted. If the company has 150 units left, these are assumed to be from the earliest acquisitions. To value this ending inventory, you assign costs from the earliest purchases forward, so the 150 units would be costed using the beginning inventory (100 units at $10) and the next purchase (50 units at $12), for an ending inventory value of $1,600.
The Cost of Goods Sold (COGS) is then calculated by subtracting the ending inventory value from the total cost of goods available for sale. In this example, the COGS would be $4,350 ($5,950 minus $1,600). This method provides a total COGS for the entire period and simplifies bookkeeping because it does not require a calculation after every sale.
The Perpetual LIFO Calculation Method
The perpetual LIFO method updates inventory records continuously, with a new Cost of Goods Sold (COGS) calculation after every sale. This system provides a real-time balance of inventory on hand and COGS. Each time a sale is made, the cost of the most recently purchased inventory is moved from the inventory account to the COGS account.
Using the same starting inventory as the prior example, assume the company sells 200 units. The perpetual LIFO method assigns the cost of the newest inventory first. The COGS for this sale would be calculated using the 150 units purchased at $15 and 50 units from the purchase at $12, for a total COGS of $2,850.
Following this sale, the inventory records are updated. The remaining inventory would consist of the 100 units from beginning inventory at $10 each and 150 units from the first purchase at $12 each. If another sale of 100 units occurs, the COGS would be based on the most recent remaining purchase layer ($12 per unit), adding $1,200 to the total COGS.
This method is more complex and requires inventory management software to maintain accuracy. While it offers more timely information, the administrative burden is higher than the periodic system.
Calculating the LIFO Reserve
The LIFO reserve is an accounting disclosure that shows the difference between an inventory’s value under the First-In, First-Out (FIFO) method versus the LIFO method. It is a reconciliation account, not a cash reserve, that shows how much taxable income has been deferred by using LIFO. This figure helps investors compare companies that use different inventory accounting methods.
To calculate it, subtract the ending inventory value under LIFO from the ending inventory value under FIFO. For instance, if inventory is valued at $500,000 under FIFO but reported at $420,000 under LIFO, the LIFO reserve is $80,000. This amount is disclosed in the notes to the financial statements.
A growing LIFO reserve suggests a company is experiencing rising inventory costs. The IRS requires companies using LIFO for tax purposes to also use it for financial reporting, which is known as the LIFO conformity rule. This makes the LIFO reserve a common disclosure for these businesses.