LIFO Cost Method

by Isobel Phillips, Demand Media Google
LIFO is the least-used of the costing methods and not accepted internationally.


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A business that buys, sells and stores inventory must decide how to cost materials used for production or sales, and how to value any inventory remaining at the end of the accounting period. The three main costing methods are LIFO, or last in, first out; FIFO -- first in, first out; and AVCO or average costing. The method chosen doesn't necessarily bear any relationship to the physical movement of the materials, but it must be used consistently from one period to the next.


The LIFO cost method treats the cost of current purchases as the most significant when matching costs with revenue. Its effect is that materials are issued from stores and charged to WIP, or work in progress, at their most recent price, while items remaining in inventory are valued at the oldest costs.

Perpetual & Periodic LIFO

A company may operate a perpetual inventory system, where the new balance is calculated after each movement of stock, or a periodic system in which the inventory is updated and valued at the end of the reporting period. For example, a business buys ten items at $5 each on the first of the month, sells five of them the next day and purchases another ten items at $7 each at the end of the month. Under the perpetual system, the cost of goods sold is five items at $5 each, or $25. The remaining inventory consists of five items at $5 each and ten at $7 each, making a total of $95. Using the periodic LIFO method, the cost of the five sales would only be recorded at the end of the period and at the most recent cost. The COGS would therefore be five items at $7 each, or $35, and the remaining inventory would consist of ten items at $5 each plus five items at $7 each, totaling $85.


The LIFO method ensures that in inflationary conditions, rising costs are applied to rising selling prices. The effect is to reduce profit and therefore tax, providing extra working capital for the business while the conditions prevail. The rationale is that stock must be replaced at current prices, so it makes sense to cost production at the replacement cost of materials. LIFO may also be appropriate for companies such as oil or sugar refineries that use materials in bulk, making it impossible to identify individual units purchased.


LIFO results in an out-of-date valuation of closing inventory, which is based on the oldest costs incurred. Due to this and its role in reducing profit, LIFO is banned under international financial reporting standards, although it's allowed in the United States with IRS approval. If approved for use, the IRS insists that LIFO is applied to all subsequent years unless they authorize a different system. LIFO makes it possible for managers to manipulate profits in a single year by allowing inventory to fall below normal levels, so they can use older stock at lower prices to reduce the COGS and increase profits. If this is done it must be disclosed in the notes to the financial statements.


FIFO and AVCO are the alternative costing methods. AVCO is also known as weighted average costing. The three methods produce different levels of COGS, profit and closing inventory. For example, a company buys two vacuum cleaners, one at $200 on January 1st and one at $210 on January 10th and sells one to a customer for $300 on January 15th. Under FIFO, the COGS is $200 -- the cost of the first cleaner purchased -- the profit is therefore $300 minus $200, or $100, and the closing inventory value is $210 or the cost of the second cleaner. Using LIFO under the periodic or perpetual system, the COGS is the cost of the second cleaner, or $210. The profit is therefore ($300 - $210) or $90 and the closing inventory valuation is $200. Average costing would give the COGS as ($200+$210)/2 or $205, the profit as $95 and the closing inventory as $205.

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