Definition of LIFO
Last in, First Out (LIFO) inventory costing assumes the most recent purchases are the first item sold.
A firm’s inventory is valued using the LIFO approach, which charges items utilized in a project or process at the price of the last unit acquired.
Thus, LIFO charges the cost of the most recent lot of supplies until it is consumed.
The job, department, or process then pays the next most recent lot. This leaves old materials in hand.
Materials returning from the plant to the warehouse should be considered the latest stock.
The same price as originally issued to the plant should be noted in the materials ledger card balance below all units on hand.
Explaining LIFO Inventory Valuation
LIFO employs a different cost flow theory than FIFO.
LIFO assumes stores transfer their last cost first.
Production pays for materials in reverse order of procurement.
The materials ledger cards’ later costs are utilized to cost materials requisitions, while the balance is units obtained earlier.
Advantages of LIFO
The key benefits of LIFO inventory value are:
The latest cost is levied for production.
Factory supplies are priced systematically.
Sharp material fluctuations reduce closing inventory losses.
Negatives of LIFO
LIFO inventory value has these key drawbacks:
The closing inventory value may differ from market value.
It can be difficult to keep track of many purchases of the same item at different costs.
Costing issues develop when materials are returned to the seller.
When industrial materials are returned to the warehouse, costing issues occur.
Consider these facts:
April 1: 50 $2 and 100 $4.50 inventories.
April 5: Bought 100 units at $1.80
April 06: 10 $1.80 inventory acquired on 5 April are returned to supplier.
Factory received 80 units on April 10.
Factory receives 50 units on April 15.
April 20: 20 $1.50 units bought.
April 25: Factory receives 70 units
April 30: 50 $1.70 units bought.
April 30: 10 of 25 factory-issued units returned to store.
Required: Show the LIFO inventory value on 30 April.Problems with LIFO Method
Many LIFO issues limit its usefulness. Prices, LIFO liquidation, buying behavior, and inventory turnover are major issues.
LIFO earnings and taxes rise as prices fall.
The latest and lowest prices are used to calculate the cost of products sold.
Price volatility makes some sectors unpredictable. Sugar prices surged rapidly in 2018, therefore many sugar companies switched to LIFO.
Switching to LIFO decreased their taxable income and taxes.
Sugar prices fell in 2019. This drop raised profits and taxes above FIFO levels.
LIFO users fear liquidation.
As mentioned, LIFO values at least some inventories at the firm’s early purchase prices, which may date back to LIFO’s adoption.
A company liquidates LIFO when it sells more units than it buys in a year. Thus, historical LIFO layers are liquidated and included in the current cost of goods sold.
A company is likely to sell units with 2000 or 2010 costs. Results include cheaper cost of goods sold, larger gross margin, and higher taxes.
Although organizations can plan for LIFO liquidation, events can happen beyond management’s control.
For instance, a supplier strike or unexpected demand can induce LIFO liquidation.
The 2018 annual report of Revere Copper and Brass Incorporated states:
In 2018, inventory volumes were lowered, resulting in the liquidation of LIFO inventory layers at lower costs than current acquisitions.
This increased net income by $1,772,000 or $0.31 per share, including $1,443,000 or $0.25 in the fourth quarter.
These amounts made up 8% of net income and EPS.
LIFO, especially with periodic inventories, allows management to influence profitability.
LIFO detractors say this is a drawback, even though management don’t mind.
In any event, timing purchases at the end of the year lets management evaluate product costs.
Remember that LIFO includes the latest purchases in the cost of goods sold.
Purchases made at year-end will be included in the cost of goods sold.
Purchases made at the start of the following year may become a LIFO layer in the ending inventory.
This will happen if this year’s purchases exceed sales.
A company’s inventory turnover is its sales rate. Inventory turnover affects FIFO-LIFO differentials.
When a corporation has considerable turnover, LIFO has little advantage over FIFO.
Because of a high turnover rate, FIFO-based cost of goods will approximate LIFO-based or current-cost cost of goods sold.
Thus, FIFO inventory gains are significantly reduced.
Choosing accounting principles that drive financial reporting and tax strategy is a crucial management decision.
The LIFO conformance rule makes it more significant in the LIFO versus FIFO instance.
This rule forces management to weigh the benefits of increasing cash flows against LIFO’s impact on the balance sheet and income statement.