The LIFO inventory valuation method is a common method for assigning inventory cost. The three other main inventory valuation methods are FIFO, average cost, and specific identification. FIFO, or first in first out, assumes that the first goods purchased are the first goods used or sold.
Companies can use cost flow assumptions regardless of the actual physical flow of inventory.
Inventory is recorded at historical cost, and then subject to an adjustment to the lower of cost or market (LCM).
But inventory items are purchased at different times during the year subject to different price fluctuations. Some companies, like Costco, Wal-Mart, and Home Depot, hold millions of inventory items at year-end. Imagine cases of ballpoint pens or nails coming into the retailer during the year at different times and subject to different price fluctuations.
For these companies with large inventories, tracing the original cost to every inventory item is neither cost-effective nor efficient, and one of the aims of GAAP is to present financial information only when the benefit of reporting that information exceeds the costs of obtaining it.
Though companies may track and measure each item internally for quality assurance and safety measures, it is not necessary to track the actual physical flow of inventory for financial reporting purposes.
Instead, cost flow assumptions are used to simplify inventory reporting and cost of goods sold. These cost flow assumptions, or inventory valuation methods, simplify cost of goods sold and inventory accounting by reducing information required to a few data points in the cost flow process, such as beginning inventory, purchases, and ending inventory. Items can then be identified based on a cost flow assumption, as opposed to tracking the actual cost of every inventory item that is quickly buried and obscured in the physical flow of inventory.The four main inventory cost flow assumptions are LIFO, FIFO, Average Cost, and Specific Identification.
LIFO Inventory: Lower Taxes for Rising PricesLIFO Inventory comes from the US Internal Revenue Code
The actual physical flow of inventory items which Sunny purchased over the past three months are as follows:
Actual Physical Flow of InventoryInventory Purchase two months ago:Inventory Purchase one month ago:
When Sunny sells twenty five pairs of sunglasses one sunny afternoon, it is unlikely that he knows which original order the pair of sunglasses came from. Unbeknownst to Sunny, the first twelve sunglasses came from Box 1 at $14 each, the next ten sold came from Box #2 at $15 each, and the last three pairs came from Box #3 at $16 each. If Sunny tracked every pair of sunglasses coming in, he would total his cost of goods sold based on the actual physical flow of inventory:Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:
Alternatively, Sunny can calculate cost of goods sold and ending inventory based on the cost flow assumption that the last goods ordered are the first ones sold. Since the last items ordered last week cost $16 a pair, and the amount sold was 25 pairs of sunglasses, all of the pairs sold are applied to cost of goods sold at $16 per pair, the last box ordered:Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:Total Inventory Cost of Goods Sold: $400
Similarly, ending inventory is based on the cost flow assumption that the last items in were sold, and the first items in are still here (FISH):Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:
Note that the specific identification method, LIFO and FIFO all result in total goods available for sale of $10,800, but LIFO assigns more to cost of goods sold and less to ending inventory during periods of rising prices, while FIFO assigns less to cost of goods sold and more to ending inventory during the same period.LIFO Inventory Strengths: The LIFO inventory valuation method more accurately matches current costs (COGS) with revenue, thus providing the better measure of real gross profit during rising prices.During periods of rising prices, using the LIFO inventory valuation method results in a lower income tax liability when compared to other alternatives. (However, during deflationary periods, the opposite is true).
LIFO Inventory Weaknesses:The LIFO inventory valuation method potentially misstates current inventory costs on the balance sheet when prices rise, since it assigns prices to inventory from earlier periods.Because the origins of the LIFO inventory method come from the Internal Revenue Code, LIFO is subject to more complex IRS regulations and requirements than other inventory valuation alternatives.