Meaning of LIFO Method: The LIFO (Last-In, First-Out) is an inventory management method that assumes the most recently purchased inventory is sold first, and the old inventory is sold later. It has lower applicability in a real-world scenario and is preferred only for non-perishable products with long shelf-life value.
What is LIFO Method?
LIFO can be expanded as last-in, first-out inventory. It is applied to the cost of goods sold calculation as the used cost of flow assumption. The LIFO method ensures that the recent products added to the inventory are prioritised and sold first. For, calculation, the cost paid for selling the recent product is considered first.
In simple terms, the Lifo method means the recent items in the inventory have to be expensed first as the cost of goods sold. It accounts for the recently arrived products in the inventory. There are also two other alternatives to account for the inventory. One is the Fifo method where the oldest goods in the inventory are sold first.
The average cost method is also an alternative to the LIFO and FIFO method. In this method, the weighted average of all units available for sale is calculated within an accounting period. This acquired average cost is then used to determine the cost of the goods sold and the total value of the ending inventory.
Key Takeaways:
- LIFO (Last-In, First-Out) is an inventory valuation method that assumes the most recently acquired inventory is sold first, while older inventory is sold later.
- LIFO uses the costs of the most recent inventory to calculate the Cost of Goods Sold (COGS).
- Advantages of LIFO include lower taxable revenue during inflation, higher COGS, and better alignment of recent inventory costs with current expenses.
- Sage X3 improves LIFO inventory tracking through real-time & consistent monitoring, RFID & Barcode integration, and accurate COGS calculation.
Why is LIFO Method used?
The Lifo method is used for the calculation of the cost of goods sold. Hence, it is calculated when the costs of manufacturing a product or acquiring inventory are swelling. One of the factors leading to this condition may be inflation.
If the last in-first-out LIFO method is used by the company, they may experience a decrease in revenue, however, the corporate tax will lower which is an advantage. The increase in cost could be favourable for the business for some time as the savings will be useful for other crucial business operations.
LIFO’s Impact on Inflation and Net Income
In this aspect, it is important to know about the association between LIFO, inflation and net income. Note that the inventory costing methods will produce the same result if the inflation is zero. However, if the inflation is high, the choice of inventory valuation methods will impact the valuation ratio. Let us see how last-in first-out LIFO is affected:
Note that LIFO is a method which is not a perfect solution to indicate the ending inventory value. Possibly, it can underrate the value of the inventory. Further, when the cost of goods sold is high, LIFO results in reduced net income. However, whenever there is inflation, there are fewer inventory write-ups under LIFO.
Example of LIFO Method
We have learned that LIFO is a method used to evaluate the value of inventory for accounting purposes. The most recently produced goods are sold and the value is calculated in the LIFO method. Let us learn deeply about the last in, first out LIFO with an example.
- Let us take an example of a small electronic that uses the LIFO inventory valuation method.
- Assume that in January, the store purchased 10 smartphones for the price of Rs 15,000 each.
- Further, in February, the store again purchased 15 more smartphones for Rs 16,000 each due to a promotional event.
- Hence, when they sell the smartphones in March, the 12 smartphones will be sold first as it is the most recent product. It will be sold for Rs 16,000 each. The total cost of goods sold COGS will be Rs 1,92,000 (12 phones x Rs 16,000).
- The remaining 3 phones are valued at Rs 16,000 each for ending inventory. This method ensures that the newest items are sold first.
Also Read : What is the FIFO method in Inventory? Definition and how to use it?
Advantages of LIFO
Some of the key advantages of LIFO are reduced taxable income, better cash flow during inflation, accurate inventory valuation, higher COGS, and reduced risk of inventory obsolescence.
1. Reduced Tax Liability (Inflation Period)
Companies may adopt the LIFO method to reduce their pre-tax profit on paper. During the period of inflation, they may benefit from reduced tax liability.
2. Better Cash Flow
In case of inflationary time, businesses may use the LIFO inventory method for cash benefits. It frees up additional capital that can be used for various purposes such as operating expenditure, debt, or new investments.
3. Accurate Inventory Valuation
In the case of the LIFO method, the COGS considers the most recent costs, leading to more current pricing information in the company’s books of accounts. This helps businesses accurately perform a more realistic valuation of their stock.
4. Higher Cost of Goods Sold (COGS)
Unlike FIFO inventory method, the COGS is higher which can help current costs of production in changing market environment.
5. Reduced Risk of Inventory Obsolescence
The risk of inventory obsolescence is important, especially in a declining market pricing environment. In the LIFO method, businesses keep stocks with lower market value, which reduces the risk of stock obsolescence.
Disadvantages of LIFO
The major disadvantages of LIFO are higher tax liability during deflation periods, misleading accounting data, accounting complexities, inventory liquidation risks, and limited applicability.
1. Higher Tax Liability (Deflation Period)
LIFO is a preferred method during the inflation period. However, during the period of deflation — when market prices fall rapidly — it increases the risk of higher tax liability despite lower actual profits.
2. Misleading Accounting Data
The LIFO method is often criticised for presenting an inaccurate representation of the company’s financial statements, especially during the inflation period. The lower reported profits bring less tax revenue to government bodies.
3. Accounting Complexities & Delays
Compared to FIFO, the LIFO method is more complex and time-consuming as it requires meticulous record-keeping. It adds unnecessary accounting complexities, leading to diversion of the company’s resources.
4. Inventory Liquidation Risks
While the LIFO method is helpful during periods of inflation, it can lead to inventory liquidation risks during deflation periods. Despite lower actual profits, the profits on the books of accounts may inflate.
5. Limited Applicability
It is not a recommended method for many industries, including the food & beverage industry, where companies deal with perishable goods. Its applicability depends on your country’s regulatory standards, industry, and inventory type.
Why is LIFO accounting banned in most parts Worldwide?
The International financial reporting standards are followed by most of the businesses. Depending on these standards, LIFO is banned in most parts of the world as it will lower the taxable income. The Governments are not favourable even if there is no inflation. It is possible that the LIFO valuation method can deliver inaccurate results.
It is essential to note that executing the LIFO accounting method in the initial years can potentially lead to artificial inflation of a company’s earnings during its liquidation process, posing a risk to accurate financial assessment.
When to use LIFO?
Last in, first out LIFO can be applied if the cost of inventory is inflating. Use LIFO method if the cost of the inventory is likely to increase. So, what is LIFO method? Under LIFO, the most recently purchased goods in the inventory are sold first. This will result in higher costs and lower revenue. Meanwhile, it reduces even the taxable income. LIFO is used by companies such as oil and gas companies, and retail and car dealerships.
Which is better: LIFO or FIFO
Whether LIFO or FIFO is better solely depends on the nature of your business, your operating industry, and your country’s regulatory framework. Public companies prefer FIFO over LIFO as the latter reduces net income on paper, which may not be in the best interests of their shareholders. As LIFO is banned in India, it’s not relevant in the Indian context.
LIFO is primarily preferred by companies with a huge inventory base at all times. They lower their reported taxes by matching sales with high costs. Similarly, companies may prefer the LIFO method during rising inflation to reduce their taxable income.
How ERP Software Improves LIFO Inventory Tracking & Valuation?
ERP software improves LIFO inventory tracking and valuation through improved inventory tracking, RFID & Barcode integration, improved business decisions, accurate COGS, and reduced data entry.
1. Accurate Inventory Tracking
ERP software improves the accuracy of inventory tracking and reduces human errors, giving a more accurate picture of your inventory levels.
2. RFID & Barcode Integration
The ERP application supports integration with RFID and Barcode technologies, which helps improve the overall efficiency and accuracy.
3. Improved Business Decisions
ERP consolidates data from different sources, providing up-to-the-minute insights at your fingertips, which is critical for strategic inventory-centric decision-making.
4. Accurate COGS
ERP software helps accurately calculate the Cost of Goods Sold (COGS), which is crucial under the LIFO method. For example, it automatically updates the cost records every time you sell your goods.
5. Reduced Data Entry
ERP system deeply integrates across purchases, sales, and accounting modules, promoting smooth consolidation of data across different sources. Not only does it reduce manual labor, but it also frees up your staff for more value-adding activities.
Conclusion
The Lifo method is used to account for inventory that is recent and which is sold first. It is used for specific companies during particular times such as inflation etc. Companies with large and costly inventories use LIFO. ERP software is the best software to manage all the activities of the inventory efficiently maintaining all the standards.
Frequently Asked Questions (FAQs)
1. What is the LIFO Method Formula?
Since LIFO is an inventory method, it does not have a single formula. However, the following formulas are used for its successful adoption in a company.
Cost of Goods Sold (COGS) = Units Sold x Cost of Most Recent Purchases
Ending Inventory = Beginning Inventory + Total Purchases – COGS
2. What is the LIFO Method in Cost Accounting?
The LIFO (Last-In, First-Out) method in cost accounting assumes the most recently purchased inventory is sold first and the older one is sold last. A company adopting this method calculates the COGS from the cost of recent inventory.
3. What is FIFO & LIFO in Inventory Management?
FIFO (First-In, First-Out) is an inventory method that assumes the oldest inventory is sold first and the most recent later. In contrast, LIFO (Last-In, First-Out) assumes the newest inventory is sold first and the oldest later. While FIFO has widespread applicability, the LIFO method is not permitted under the International Financial Reporting Standards (IFRS).
