Definition of Last in First out Method
The last in first out method (LIFO) of inventory valuation is a method under which the materials used in a job or process are charged at the price of last units purchased. In other words, the cost of the most recent lot of materials purchased is charged until the lot is exhausted, then the next recent lot’s price is charged to, the job or department or process. This results in leaving an old lot of materials in hand.
The return of materials, from factory to the store-room be treated as, most recent stock on hand and be placed in the materials ledger card balance below of all the units in hand at the same price as it was issued to the factory.
Explanation of LIFO Method of Inventory Valuation
The principle as to flow of cost followed by the last in first out method is opposite to that of FIFO. LIFO assumes the last cost received in stores is the first cost that goes out from stores. Cost of materials is charged to production in the reverse order of purchases. The later costs recorded in materials ledger cards are used for costing materials requisitions and the balance is composed of units received earlier.
Advantages of LIFO
Following are the main advantages of last in first out (LIFO) method of Inventory Valuation.
- Production is charged with the most recent cost.
- Material issued to factory is priced in a systematic manner.
- When there is sharp materials fluctuation. The closing inventory losses are minimized.
Disadvantages of LIFO
Last in First out (LIFO) method of inventory valuation has the following major drawbacks.
- The value of closing inventory may be different from the current market value,
- The record-keeping may become difficult when number of purchase made of the same material at different prices.
- Under LIFO method costing difficulties arise when material is returned, to vendor when material is returned from the factory tp storeroom the problem of costing arises.
- When Material is returned from the factory to storeroom the problem of costing arises.
LIFO Method Example:
- April 01: Inventories on hand: 50 units at the rate of $2 and 100 units at the rate of $4.50.
- April 05: Purchased 100 units at a rate of $1.80.
- April 06: 10 units of the inventories purchased on 5th April at the rate of $1.80 are returned to supplier.
- April 10: 80 units were issued to factory.
- April 15: 50 units were issued to factory.
- April 20: 20 units were purchased at a rate of $1.50.
- April 25: 70 units were issued to the factory.
- April 30: 50 units purchased at $1.70.
- April 30: Out of units issued to factory on 25th April, 10 units were returned to the store.
Using the last in first out (LIFO) method, show the value of inventory in hand on 30th April.
Issues related to LIFO (Last-in-First-out) Method
There are a number of issues and problems related to LIFO that can decrease its advantages. Some of the more important ones are the effects of prices, LIFO liquidation, purchasing behavior, and inventory turnover.
When prices decrease, LIFO shows higher earnings and, as a result, higher taxes. This is because the latest and, in this case, the lowest prices are allocated to cost of goods sold. In some industries, prices are volatile and thus unpredictable. For example, in 2018 a number of sugar companies changed to LIFO as sugar prices rose at a rapid pace. By switching to LIFO, these companies reduced their taxable income and their resulting tax payments. However, in 2019, sugar prices declined. The result of this decline was an increase in earnings and tax payments over what they would have been on a FIFO basis.
The potential of LIFO liquidation is a major concern to LIFO users. As we noted, at least a portion of the inventories costed under LIFO is priced at the firm’s early purchase prices, which might go back to the date when LIFO was adopted. LIFO liquidation occurs when a firm sells in any year more units than it purchases. Thus LIFO layers that have been built up in the past are liquidated, that is, included in the current period’s cost of goods sold. In effect, a firm is apt to sell units that may have 2000 or 2010 costs attached to them.
The result is a lower cost of goods sold, higher gross margin, and higher taxes. Although firms can often plan for LIFO liquidation, events sometimes happen that are beyond management’s control. For example, a supplier’s strike or an unanticipated demand can cause unplanned LIFO liquidation. As an example, Revere Copper and Brass, Incorporated reported the following in its 2018 annual report:
During 2018 inventory quantities were reduced resulting in a liquidation of certain LIFO inventory layers carried at costs which were lower than the cost of current purchases, the effect of which increased net income by approximately $1,772,000 or $.31 per share including $1,443,000 or $.25 per share in the fourth quarter.
These amounts represented about 8% of net income and earnings per share.
The use of LIFO, especially in connection with the periodic inventory method, offers management a certain degree of flexibility to manipulate profits. Although from management’s perspective this certainly is not a problem, critics of LIFO point to this ability as a disadvantage of LIFO. In any event, by timing purchases at year-end, management is able to determine what costs will be allocated to the cost of goods. Remember that under LIFO, the latest purchase will be included in cost of sold. Thus, by making a purchase at year-end, the cost of that purchase will be included in cost of goods sold. A purchase at the beginning of the next year, however, could end up in next year’s ending inventory as a new LIFO layer if the units purchased during this year exceed the units sold.
Inventory turnover, or the rate at which a company sells its inventory, can affect the differential between FIFO and LIFO. When a company has a high turnover rate, the LIFO advantage over FIFO is not as great, because with a high turnover rate, a FIFO-based cost of goods will approximate a LIFO-based or current-cost cost of goods sold. Thus inventory profits usually found in connection with FIFO are substantially decreased.
In summary, the selection of accounting principles for both financial reporting and tax purposes is an important management decision. In the LIFO versus FIFO use, it is even more important because of the LIFO conformity rule whereby management is forced to consider the utility of increased cash flows versus the effect LIFO will have on the balance sheet and income statement.