How to Perform the LIFO Method Calculation

The Last-In, First-Out (LIFO) method is an accounting technique for valuing inventory. It assumes that the most recently acquired inventory items are the first ones sold. This method is permitted in the United States under Generally Accepted Accounting Principles (GAAP). LIFO can be advantageous for businesses during periods of rising prices, as it can lead to a higher Cost of Goods Sold (COGS) and, consequently, lower taxable income.

Core Concepts of LIFO Cost Flow

The fundamental principle of LIFO is that the cost of the last items purchased or produced is the first to be recognized as an expense when goods are sold. This is a cost flow assumption, meaning it dictates how costs are assigned for accounting purposes, not necessarily the physical movement of goods. For instance, a company might physically sell its oldest inventory first to prevent obsolescence, but still use LIFO for financial reporting.

LIFO operates on the concept of “inventory layers.” Each new inventory purchase forms a new layer. When a sale occurs, LIFO assumes the items sold come from the newest, or “last-in,” layer. This approach matches the most recent costs against current revenues, leading to a higher COGS. Conversely, older, potentially lower costs remain in the inventory valuation on the balance sheet.

Preparing Your Inventory Records for LIFO Application

Accurate record-keeping is fundamental to correctly applying the LIFO method. Businesses must maintain comprehensive records of all inventory purchases, documenting the date, quantity, and unit cost for every item. This tracking allows for the proper identification of distinct inventory layers.

Businesses also need to keep thorough records of all inventory sales, including the date and quantity of units sold. Maintaining chronological accuracy for both purchases and sales is paramount. This ensures that when a sale occurs, the correct “last-in” inventory layer can be identified and the appropriate cost assigned to the Cost of Goods Sold.

Step-by-Step LIFO Calculation for Cost of Goods Sold

Calculating the Cost of Goods Sold (COGS) using the LIFO method involves systematically assigning the costs of the most recent inventory purchases to the units sold. First, identify the total number of units sold during the accounting period. Then, look to your most recent inventory purchase records, as the cost of these newest units will be expensed first.

For example, assume a business sold 15 units. Its inventory purchases were: 10 units at $10 each (oldest), then 5 units at $12 each, and finally 10 units at $15 each (newest). Under LIFO, the 15 units sold would first draw from the newest 10 units at $15 each, totaling $150. The remaining 5 units needed would then come from the next most recent purchase, the 5 units at $12 each, totaling $60. Therefore, the total COGS for these 15 units would be $150 + $60 = $210. This process continues backward through inventory layers until all sold units have a cost assigned.

Valuing Remaining Inventory with LIFO

After calculating the Cost of Goods Sold, the next step is to determine the value of the remaining inventory under the LIFO method. Under LIFO, the ending inventory consists of the oldest inventory layers that have not yet been expensed. This means the costs assigned to the inventory remaining on the balance sheet are from the earliest purchases.

To calculate this value, identify the units that were not considered sold in the COGS calculation. These remaining units will be from the oldest inventory layers. For instance, continuing the previous example, after selling 15 units (10 from the $15 layer and 5 from the $12 layer), the remaining inventory would consist of the initial 10 units purchased at $10 each. The value of this ending inventory would be 10 units $10/unit = $100. This method ensures the balance sheet reflects the cost of the oldest inventory, while the income statement captures the cost of the most recently acquired goods.