LIFO layer definition
/What is a LIFO Layer?
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.
Impact of LIFO Layers on Profits
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. Conversely, if an old LIFO layer contains an unusually high-cost item, then the reverse situation can occur, where the cost of goods sold is unusually high, resulting in a reduced profit.
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.
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Example of a LIFO Layer
Milagro Corporation decides to use the LIFO method for the month of March. The following table shows the various purchasing transactions for the company’s Elite Roasters product. The quantity purchased on March 1 actually reflects the inventory beginning balance.
The following bullet points describe the transactions noted in the preceding table:
March 1. Milagro has a beginning inventory balance of 150 units, and sells 95 of these units between March 1 and March 7. This leaves one inventory layer of 55 units at a cost of $210 each.
March 7. Milagro buys 100 additional units on March 7, and sells 110 units between March 7 and March 11. Under LIFO, we assume that the latest purchase was sold first, so there is still just one inventory layer, which has now been reduced to 45 units.
March 11. Milagro buys 200 additional units on March 11, and sells 180 units between March 11 and March 17, which creates a new inventory layer that is comprised of 20 units at a cost of $250. This new layer appears in the table in the “Cost of Layer #2” column.
March 17. Milagro buys 125 additional units on March 17, and sells 125 units between March 17 and March 25, so there is no change in the inventory layers.
March 25. Milagro buys 80 additional units on March 25, and sells 120 units between March 25 and the end of the month. Sales exceed purchases during this period, so the second inventory layer is eliminated, as well as part of the first layer. The result is an ending inventory balance of $5,250, which is derived from 25 units of ending inventory, multiplied by the $210 cost in the first layer that existed at the beginning of the month.