LIFO Inventory Method

By Yuriy Smirnov Ph.D.

Definition

Last-in, first-out or LIFO inventory method is applied to calculate the cost of goods sold (COGS) and the inventory account balance at the end of the accounting period. It assumes that inventories bought last should be sold first. In other words, inventories should be assigned to the cost of goods sold in the reverse order they arrived in stock.

Let’s assume that each batch is a separate layer shown in the figures below.

The beginning inventory of 195 units is presented by 4 batches shown in the order they came in stock (Batch 1 came first, and Batch 4 came last).

The next transaction was the sale of 80 units (Figure 2). Because the LIFO inventory method is applied, we should assign all of Batch 4 and 20 units of Batch 3 to the cost of goods sold. Batch 1 and Batch 2 remain unaffected.

The company then replenished stock by purchasing another 55 units (Figure 3).Thus, the inventory on hand is now 170 units.

Please note that if another sale takes place Batch 5 will be assigned first!

Examples

XYZ Ltd has made following transactions during the first quarter:

Let’s calculate the inventory account balance on 31st of March and cost of goods sold (COGS) using the LIFO inventory method.

LIFO Periodic

If XYZ Ltd uses the periodic inventory system, the ending inventory is computed as the sum of beginning inventory and total purchases during the accounting period less number of units sold.

Total purchases = 75,000 + 90,000 + 60,000 = 225,000 units

Units sold = 23,000 + 27,000 + 35,000 + 65,000 + 35,000 + 42,000 = 227,000 units

Ending Inventory = 45,000 + 225,000 – 227,000 = 43,000 units

The total amount of each sale’s cost comprises the cost of goods sold. Please note that the last batch is assigned to the cost of goods sold first.

Cost of Jan 15 sale = 23,000 × $165 = $3,795,000

Cost of Jan 27 sale = 27,000 × $165 = $4,455,000

Cost of Feb 3 sale = 25,000 × $165 + 10,000 × $150 = $5,625,000

Cost of Feb 21 sale = 65,000 × $175 = $11,375,000

Cost of Mar 14 sale = 35,000 × $170 = $5,590,000

Cost of Mar 25 sale = 25,000 × $170 + 17,000 × $175 = $7,225,000

The cost of goods sold in the first quarter totaled $38,425,000.

The ending inventory of 43,000 units consists of 35,000 units from the beginning inventory at a cost of $150 per unit and purchase made on 12th of February of 8,000 units at a cost of $175 per unit. Thus, the inventory account balance totals $7,310,000 at the end of the first quarter.

Ending Inventory = 35,000 × $150 + 8,000 × $175 = $6,650,000

LIFO Perpetual

If the LIFO perpetual inventory system is used, the inventory account balance and cost of goods sold are updated after each transaction, which can be expressed as follows:

Jan 1

Inventory Account Balance = 45,000 × $150 = $6,750,000

Jan 10

Inventory Account Balance = $6,750,000 + 75,000 × $165 = $19,125,000

Jan 15

COGS = 23,000 × $165 = $3,795,000

Inventory Account Balance = $19,125,000 – $3,795,000 = $15,330,000

Jan 27

COGS = 27,000 × $165 = $4,455,000

Inventory Account Balance = $15,330,000 – $4,455,000 = $10,875,000

Feb 3

COGS = 25,000 × $165 + 10,000 × $150 = $5,625,000

Inventory Account Balance = $10,875,000 – $5,625,000 = $5,250,000

Feb 12

Inventory Account Balance = $5,250,000 + 90,000 × $175 = $21,000,000

Feb 21

COGS = 65,000 × $175 = $11,375,000

Inventory Account Balance = $21,000,000 – $11,375,000 = $9,625,000

Mar 4

Inventory Account Balance = $9,625,000 + 60,000 × $170 = $19,825,000

Mar 14

COGS = 35,000 × $170 = $5,590,000

Inventory Account Balance = $19,825,000 – $5,590,000 = $13,875,000

Mar 25

COGS = 25,000 × $170 + 17,000 × $175 = $7,225,000

Inventory Account Balance = $13,875,000 – $7,225,000 = $6,650,000

As of March 31, the ending inventory is $6,650,000, and the cost of goods sold is $38,425,000.

Please note that both the periodic and perpetual LIFO inventory system lead to the same result!

LIFO Inventory Journal Entries

There is a difference between journal entries made in the perpetual and periodic inventory system. Let’s assume that RetailPro Ltd is a retailer selling only one product. It completed the following transactions during June.

Perpetual Inventory System

In the perpetual inventory system, “Inventory” and “Cost of Goods Sold” accounts are updated each time a purchase or sale is made.

Jun 1

Inventory is represented by 3,000 units at a cost of $75 per unit.

Beginning inventory = 3,000 × $75 = $225,000

Jun 6

Sales = 1,600 × $100 = $160,000

COGS = 1,600 × $75 = $120,000

Inventory Account Balance = $225,000 – $120,000 = $105,000

Jun 9

Purchase = 4,500 × $80 = $360,000

Inventory Account Balance = $105,000 + $360,000 = $465,000

Jun 14

Sales = 2,300 × $110 = $253,000

COGS = 2,300 × $80 = $184,000

Inventory Account Balance = $465,000 – $184,000 = $281,000

Jun 23

Sales = 2,800 × $110 = $308,000

COGS = 2,200 × $80+600 × $75 = $221,000

Inventory Account Balance = $281,000 – $221,000 = $60,000

Jun 27

Purchase = 3,500 × $90 = $315,000

Inventory Account Balance = $60,000 + $315,000 = $378,050.85

Assuming that all purchases and sales are made on credit, the following journal entries should be made:

In the perpetual inventory system, a sale requires two entries in the general journal. The first should be recorded by debiting accounts receivable and crediting sales account by sales value. The second should be recorded by debiting cost of goods sold account and crediting the inventory account by the cost of inventory.

Purchase of inventory is recorded by debiting the inventory account and crediting accounts payable by the amount to be paid.

Periodic Inventory System

In the periodic inventory system, all purchases are recorded in the “Purchases” account. In contrast, the “Inventory” account is updated one time at the end of the accounting period. If all sales and purchases are made on credit, the journal entries are as follows:

Sale of inventory is recorded in the journal by debiting the “Accounts Receivable” account and crediting the “Sales” account. Purchase of inventory is recorded by debiting the “Purchases” account and crediting the “Accounts Payable” account.

Finally, we should make a closing entry at the end of the accounting period to update the “Inventory” account. As RetailPro Ltd is using the LIFO inventory method, the closing entry is made as follows:

Advantages and Disadvantages

Advantages of LIFO

Advantages of the LIFO inventory method:

1. LIFO complies with the matching principle as the best among other inventory methods. In other words, most recent costs match current revenues.
2. Ending inventory better reflects the current market price because it is represented by the most recent batches.
3. In a period of inflation, LIFO helps to reduce tax payments.
4. It is easy to use and operate if a company does not have voluminous transactions.

Disadvantages of LIFO

Disadvantages of the LIFO inventory method:

1. Using this method is prohibited by many accounting standards (incl. IFRS) and is not accepted by many tax authorities around the globe because it helps to understate profit and pay lower taxes compared with other inventory methods.
2. In a period of inflation, ending inventory does not accurately reflect its current market price because it consists of the oldest batches with the lowest prices, which means that inventory on hand is understated.
3. If a company sells all inventory on hand, profit will be overstated, and a higher tax payment will be paid.
4. If a company has a large number of transactions and the prices of goods fluctuate significantly, it can be difficult and cumbersome to manage inventories using the LIFO method.