The main feature of the LIFO (last-in, first-out) method for cost of goods sold is that it selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
What about the ending inventory — the products you haven’t sold by the end of the year? Using the LIFO method, the earliest cost remains in the inventory asset account (unless all products are sold and the business has nothing in inventory).
How LIFO works
Suppose that you acquire four units of a product during a period, one unit at a time, with unit costs as follows (in the order in which you acquire the items): $100, $102, $104, and $106. If you sell three units during the period, the LIFO method calculates the cost of goods sold expense as follows:
$106 + $104 + $102 = $312
With LIFO, you use the last three units to calculate cost of goods sold expense. The ending inventory cost of the one unit not sold is $100, which is the oldest cost.
The $412 total cost of the four units acquired less the $312 cost of goods sold expense leaves $100 in the inventory asset account. Determining which units you actually delivered to customers is irrelevant; when you use the LIFO method, you always count backward from the last unit you acquired.
Why LIFO works
The two main arguments in favor of the LIFO method are these:
Assigning the most recent costs of products purchased to the cost of goods sold expense makes sense because you have to replace your products to stay in business, and the most recent costs are closest to the amount you will have to pay to replace your products.
Ideally, you should base your sales prices not on original cost but on the cost of replacing the units sold.
During times of rising costs, the most recent purchase cost maximizes the cost of goods sold expense deduction for determining taxable income, and thus minimizes income tax.
In fact, LIFO was invented for income tax purposes. True, the cost of inventory on the ending balance sheet is lower than recent acquisition costs, but the taxable income effect is more important than the balance sheet effect.
The problems with LIFO
Here are the reasons why LIFO is problematic:
Unless you are able to base sales prices on the most recent purchase costs or you raise sales prices as soon as replacement costs increase — and most businesses would have trouble doing this — using LIFO depresses your gross margin and, therefore, your bottom-line net income.
The LIFO method can result in an ending inventory cost value that’s seriously out of date, especially if the business sells products that have very long lives.
Unscrupulous managers can use the LIFO method to manipulate their profit figures if business isn’t going well. They let their inventory drop to abnormally low levels, with the result that old, lower product costs are taken out of inventory to record cost of goods sold expense.
This gives a one-time boost to gross margin. These “LIFO liquidation gains” — if sizable in amount compared with the normal gross profit margin that would have been recorded using current costs — have to be disclosed in the footnotes to the company’s financial statements.
If you sell products that have long lives and for which your product costs rise steadily over the years, using the LIFO method has a serious impact on the ending inventory cost value reported on the balance sheet and can cause the balance sheet to look misleading. Over time, the current cost of replacing products becomes further and further removed from the LIFO-based inventory costs.
