A LIFO layer refers to a tranche of cost in an inventory costing system that follows the last-in, first-out (LIFO) cost flow assumption. In essence, a LIFO system assumes that the last unit of goods purchased is the first one to be used or sold. This means that the most recent costs of acquired goods tend to be charged to expense quite soon, while the earlier costs of acquired goods linger in the costing records, possibly for years.
Since goods tend to be purchased in bulk, the LIFO concept can result in large numbers of units kept in stock, with each block of units recorded at a different price point, or LIFO layer. If a company continues to acquire and maintain a large number of units in stock, this can mean that a number of LIFO layers are associated with each inventory item, where each layer has a different cost.
When an unusually large number of units are released from stock, doing so peels away one or more LIFO layers. When these layers are removed, the costs associated with them are charged to expense. If a LIFO layer is an extremely old one, it may have a cost that is significantly different from the market price at which inventory could currently be acquired, so that the amount charged to expense may be much higher or lower than would normally be the case.
In the typical inflationary cost environment, accessing an old LIFO layer means that a business will likely report a low cost of goods sold and therefore a higher-than-usual profit, which in turn means that it may have to pay an unusually large amount of income tax.
For example, a company buys 100 green widgets for $10 in January, another 100 widgets in February for $8, and yet another 100 widgets in March for $6. Each of these purchases represents a different LIFO layer. If the company sells 110 widgets in April, it will charge to expense the entire LIFO layer that has a per-unit cost of $6, as well as 10 units from the next most recent layer, which has a cost of $8 per unit. This will leave one LIFO layer of 100 units at $10 each, and one layer of 90 units at $8 each.
Given the possibly major impact of LIFO layers on reported profitability, management should be aware of any unusual cost tranches that may be accessed when inventory levels change. The cost accountant can provide them with this information.