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The Last-in, First-out Method | LIFO Inventory Method

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Overview of the Last-in, First-out Method

The LIFO method of inventory valuation assumes that the last goods purchased are the first goods used or sold.  This allows the matching of current costs with current revenues and provides the best measure of gross profit.  However, unless costs remain relatively unchanged over time, the LIFO method will usually misstate the ending inventory balance sheet amount because LIFO inventory usually includes costs of acquiring or manufacturing inventory that were incurred in earlier periods.  LIFO does not usually follow the physical flow of merchandise or materials.  However, the matching of physical flow with cost flow is not an objective of accounting for inventories.

Under the LIFO method, the quantity of ending inventory on hand at the beginning of the year of election is termed the base layer.  This inventory is valued at actual (full absorption) cost, and unit cost for each inventory item is determined by dividing total cost by the quantity on hand.  At the end of the initial and subsequent years, increases in the quantity of inventory on hand are referred to as increments, or LIFO layers.  These increments are valued individually by apply­ing one of the following costing methods to the quantity of inventory representing a layer:

• The actual cost of the goods most recently purchased or produced
• The actual cost of the goods purchased or produced in order of acquisition
• An average unit cost of all goods purchased or produced during the current year
• A hybrid method that more clearly reflects income

Thus, after using the LIFO method for five years, it is possible that an enterprise could have ending inventory consisting of the base layer and five additional layers (or increments) provided that the quantity of ending inventory increased every year.

Example of the Last-in, First-out Method

The single goods (unit) LIFO approach is illustrated in the following example:

Rose Co. is in its first year of operation and elects to use the periodic LIFO method of inventory valuation.  The company sells only one product.  Rose applies the LIFO method using the order of current year acquisition cost.  The following data are given for years 1 through 3:

		Units			Purchase cost
Year 1	Beginning inventory	Purchased	Sold	Ending inventory	Unit cost	Total cost
Purchase		200			$2.00	$400
Sale			100		___	___
Purchase		200			3.00	600
Sale	___	___	150	___	___	___
	__	400	250	150
Year 2
Purchase		300			$3.20	$960
Sale			200		___	___
Purchase	___	100	___	___	3.30	330
	150	400	200	350
Year 3
Purchase		100			$3.50	$350
Sale			200		___	___
Sale	___	___	100	___	___	___
	350	100	300	150

In year 1 the following occurred:

• The total goods available for sale were 400 units
• The total sales were 250 units
• Therefore, the ending inventory was 150 units

The ending inventory is valued at the earliest current year acquisition cost of $2.00 per unit.  Thus, ending inventory is valued at $300 (150 × $2.00).

Another way to look at this is to analyze both cost of goods sold and ending inventory.

	Units	Unit cost	Total cost
Cost of goods sold	200	$3.00	$600
	50	2.00	100
	250		$700
Ending inventory	150	2.00	$300

Note that the base-year cost is $2.00 and that the base-year level is 150 units.  Therefore, if ending inventory in the subsequent period exceeds 150 units, a new layer (or increment) will be created.

Year 2	Units	Unit cost	Total cost
Cost of goods sold	100	$3.30	$330
	100	3.20	320
	200		$650
Ending inventory	150	2.00	$300	Base-year layer
	200	3.20	640	Year 2 increment
	350		$940

If ending inventory exceeds 350 units in the next period, a third layer (increment) will be cre­ated.

Year 3	Units	Unit cost	Total cost
Cost of goods sold	100	$3.50	$350
	200	3.20	640
	300		$990
Ending inventory	150	2.00	$300	Base-year layer

Notice how the decrease (decrement) of 200 units in year 3 eliminated the entire year 2 in­crement.  Thus, any year 4 increase in the quantity of inventory would result in a new increment which would be valued at year 4 prices.

In situations where the ending inventory decreases from the level established at the close of the preceding year, the enterprise experiences a decrement or LIFO liquidation.  Decre­ments reduce or eliminate previously established LIFO layers.  Once any part of a LIFO layer has been eliminated, it cannot be reinstated after year-end. 

For example, if in its first year after the election of LIFO an enterprise establishes a LIFO layer (increment) of ten units, then in the next year inventory decreases by four units leaving the first layer at six units, the enterprise is not permitted in any succeeding year to increase the number of units in the first year layer back up to the original ten units.  The quantity in the first layer remains at a maximum of six units subject to further reduction if decrements occur in future years.  Any unit increases in future years will create one or more new layers.  The effect of LIFO liqui­dations in periods of rising prices is to transfer, from ending inventory into cost of goods sold, costs that are below the current cost being paid.  Thus, the resultant effect of a LIFO liquidation is to increase income for both accounting and income tax purposes.  Because of this, LIFO is most commonly used by companies in industries in which levels of inventories are consistently maintained or increased over time.

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