LIFO (Last-In, First-Out)
The last-in, first-out (LIFO) is an inventory valuation method that assumes that the most recently purchased items are the first items sold, meaning the newest inventory is sold before the older inventory.
This method is commonly used by companies that sell durable goods or those that have a low turnover rate of inventory, such as car dealerships or furniture stores.
When calculating the cost of goods sold and valuing the remaining inventory, LIFO assigns the cost of the most recently purchased items in stock to sales and leaves the cost of the earliest purchased items in the inventory.
How the LIFO Method Works
The LIFO method assumes that the cost of goods sold (COGS) is based on the cost of the newest inventory, while the ending inventory value is based on the cost of the oldest inventory.
Under LIFO, the assumption is that newer inventory costs have been expensed, and the remaining inventory is valued at older, lower costs.
As a result, the cost of goods sold is assigned based on the most recent purchases, while the older, lower-cost items remain in the inventory.
Example of Calculating Inventory Using LIFO
We’ll take an example of a furniture store that sells sofas.
The store purchases 50 sofas for $500 each in April, and then purchases 100 more sofas for $550 each in May. The store then sells 70 sofas in June.
Using the LIFO method, the cost of goods sold would be calculated:
- We assume that the last 70 sofas purchased in May were sold first, and therefore the cost of goods sold would be (70 sofas x $550) = $38,500.
- The ending inventory value would be the remaining 80 sofas from the April purchase, which were valued at $500 each. Therefore, the ending inventory value would be (80 sofas x $500) = $40,000.
FIFO vs LIFO: What is the Difference?
The main difference between the FIFO and LIFO methods is the order in which the goods are sold.
While the FIFO method assumes that the oldest inventory is sold first, the LIFO method assumes that the newest inventory is sold first.
The choice between using FIFO or LIFO can have a significant impact on a company’s financial statements.
For example, if the cost of goods sold is based on older, lower prices (FIFO), the company’s net income will be higher, and its taxes will be lower.
Conversely, if the cost of goods sold is based on newer, higher prices (LIFO), the company’s net income will be lower, and its taxes will be higher.