Last-in, first-out (LIFO) is an inventory method popular with companies that experience frequent increases in the cost of their product. LIFO is used primarily by oil companies and supermarkets, because inventory costs are almost always rising, but any business can use LIFO. Remember, there is no correlation between physical inventory movement and cost method.
To visualize how LIFO works, think of one of those huge salt piles that cities and towns keep to salt icy roads. The town gets a salt delivery and puts it on top of the pile. When the trucks need to be filled, does the town take the salt from the top or bottom of the pile? The trucks are filled from the top of the pile. The last delivery in is the first to be used. This is the essence of LIFO. When calculating costs, we use the cost of the newest (last-in) products first.
When costs are rising, LIFO will give the highest cost of goods sold and the lowest gross profit. LIFO will also result in lower taxes than the other inventory methods.
LIFO Using a Periodic Inventory System
For all periodic methods we can separate the purchases from the sales in order to make the calculations easier. Under the periodic method, we only calculate inventory at the end of the period. Therefore, we can add up all the units sold and then look at what we have on hand.
We sold 245 units during the month of January. Using LIFO, we must look at the last units purchased and work our way up from the bottom. Start with the 50 units from January 26th and work up the list. We would then take the 90 units from January 22nd, and 50 units from January 12th. That gives us 190 units. We are still 55 short, so we will take 55 from January 3rd.
The cost of goods sold for the 245 units, using LIFO, is $2,032.00. Now we need to look at the value of what is left in ending inventory. We have 20 units left from the January 3rd purchase and all the units from beginning inventory.
Gross profit (sales less cost of goods sold) under LIFO is $2,868.00. Under LIFO, our cost of goods sold is higher than it was under FIFO and our ending inventory is lower than under FIFO. Gross profit is lower under LIFO than FIFO, which would result in lower income taxes because overall profit would be lower.
Adding cost of goods sold and ending inventory gives us $3,394.00 which ties back to goods available for sale. Everything has been accounted for in our calculation.
Under a perpetual inventory system, inventory must be calculated each time a sale is completed. The method of looking at the last units purchased is still the same, but under the perpetual system, we can only consider the units that are on hand on the date of the sale.
Imagine you were actually working for this company and you had to record the journal entry for the sale on January 7th. We would do the entry on that date, which means we only have the information from January 7th and earlier. We do not know what happens for the rest of the month because it has not happened yet. Ignore all the other information and just focus on the information we have from January 1st to January 7th.
LIFO means last-in, first-out. Based on the information we have as of January 7th, the last units purchased were those on January 3rd. We will take the cost of those units first, but we still need another 25 units to have 100. Those units will come from beginning inventory.
The cost of the January 7th sale is $807.50. Now, we can move on to the next sale, updating our inventory figures. There are no units remaining from the January 3rd purchase and 125 left in beginning inventory. Before the January 17th sale, we purchased 50 units on January 12th.
We need 65 units for this sale. Since we are using LIFO, we must take the last units in, which would be the units from January 12th. Then we would take the remaining 15 units needed from beginning inventory.
One more sale remaining. Again, we will update the remaining units before considering the sale.
The company sold 80 units on January 31st. Which units should we use for cost using LIFO? The last units in were from January 26th, so we use those first, but we still need an additional 30. We take those from January 22nd.
To calculate total cost of goods sold, add the cost of each of the sales.
You could also add $807.50 plus $532.50 plus $673.00 which also equals $2,013.00.
You may have noticed that perpetual inventory gave you a slightly lower cost of goods sold that periodic did. Under periodic, you wait until the end of the period and then take the most recent purchases, but under perpetual, we take the most recent purchases at the time of the sale. Under periodic, none of the beginning inventory units were used for cost purposes, but under perpetual, we did use some of them. Those less expensive units in beginning inventory led to a lower cost of goods sold under the perpetual method. You will also notice that ending inventory is slightly higher. Look at the differences in the units that are left in ending inventory.
Under perpetual we had some units left over from January 22nd, which we did not have under periodic.
When using a perpetual inventory system, dates matter! Make sure to only consider the units on hand at the time of the sale and work backwards accordingly.