- Definition and explanation of LIFO method
- Example of LIFO costing method
- Advantages of Last in First Out method
- Disadvantages of Last in First Out Method
Definition and explanation:
Thelast in first out (LIFO) methodof costing materials issued is based on the premise that materials units issued should carry the cost of the most recent purchase, although the physical flow may actually be different. The method assumes that the most recent cost (the approximate cost to replace the consumed units) is most significant in matching cost with revenue in the income determination procedure.
UnderLIFO procedures, the objective is to charge the cost of current purchases towork in processor other operating expenses and to leave the oldest costs in theinventory. Several alternatives can be used to apply theLIFO method. Each procedure results in different costs for materials issued and the endinginventory, and consequently in a different profit. It is mandatory, therefore, to follow the chosen procedure consistently.
LIFO Costing Method Example:
This example is based on the following transactions:
| February (1)Beginning balance: 800 units @ $6 per unit. (4)Received 200 units @ $7 per unit. (10)Received 200 units @ $8 per unit. (11)Issued 800 units. (12)Received 400 units @ $8 per unit. (20)Issued 500 units. (25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price. (28)Received 600 units @ $9 per unit. |
Calculations for the above transactions would be as follows
LIFO COSTING METHOD
| February: 1. Beginning balance |
800 units @ $6.00 |
|
|
| 4. Received | 200 units @ $7.00 | $1,400 | |
| 10.Received | 200 units @ $8.00 | $1,600 | $7,800 |
| 11. Issued | 200 units @ $8.00 | $1,600 | |
| 200 units @ $7.00 | $1,400 | ||
| 400 units @ $6.00 | $2,400 | $5,400 | |
|
Balance |
400 units @ $6.00 | $2,400 | |
| Received | 400 units @ $8.00 | $3,200 | $5,600 |
| 20. Issued | 400 units @ $8.00 | $3,200 | |
| 100 units @ $6.00 | $600 | $3,800 | |
|
Balance |
300 units @ $6.00 | $1,800 | |
| 25. Returned to storeroom | 100 units @ $6.00 | $600 | |
| 28. Received | 600 units @ $9.00 |
$5,400 |
$7,800 |
|
Balance |
400 units @ $6.00 |
$2,400 |
|
| 600 units @ $9.00 |
$5,400 |
$7,800 |
The basic difference between the various applications of this costing method is the time interval betweeninventorycomputations. In this example of LIFO costing a newinventorybalance is computed after each receipt and each issue of materials, with the endinginventoryconsisting of 1,000 units valued at $7,800. If, however, a physical rather than a perpetual costing procedure is used, whereby the issues are determined at the end of the period by ignoring day to day issues and by subtracting total endinginventoryfrom the total of the opening balance plus the receipts, the endinginventorywould consist of:
| 800 units @ $6 on hand in the beginninginventory 200 units @ $7 from the oldest purchase, Feb. 4 1,000 units, LIFOinventoryat the end of February. |
$4,800 |
Both procedures are appropriate applications of the LIFO method, even though the cost of materials used and the endinginventoryfigures differ. Such a difference does not occur inFIFO costing method.
Regardless of the cost flow assumptions, this later procedure is particularly appropriate in process costing where individual materials requisitions are seldom used and the materials move into process in bulk lots, as in floor mills spinning mills, oil refineries, and sugar refineries. The procedure also functions smoothly for a company that charges materials towork in processfrom month end consumption sheets which provide the cost department with quantities used.
Advantages of Last In First Out (LIFO) Method:
The advantages of the last in first out method are:
Materials consumed are priced in a systematic and realistic manner. It is argued that current acquisition costs are incurred for the purpose of meeting current production and sales requirements; therefore, the most recent costs should be charged against current production and sales.
Unrealizedinventorygains and losses are minimized, and reported operating profits are stabilized in industries subject to sharp materials price fluctuations.
Inflationary prices of recent purchases are charged to operations in periods of rising prices, Thus reducing profits, resulting in a tax saving, and therewith providing acash advantagethrough deferral of income tax payments. The tax deferral creates additional working capital as long as the economy continues to experience an annualinflationrate increase.
Disadvantages of the LIFO Costing Method:
The disadvantages or limitations of the last in first out costing method are:
- The election of last in first out for income tax purposes is binding for all subsequent years unless a change is authorized or required by theInternal Revenue Service(IRS)
- This is a “cost only” method with no right down to the lower of cost or market allowed for income tax purposes. Furthermore, the IRS requires that when last in first out is adapted an adjustment must be made to restore any previous right downs from actual cost. Should the market decline below LIFO cost in subsequent years, thebusinesswould be at a tax disadvantage. When prices drop the only option may be to charge off the older (higher) cost by liquidating theinventory, however, liquidation for income tax purposes must take place at the end of the year. According to IRS regulations, liquidation during the fiscal year is not acceptable if theinventoryreturns to its original level at the end of the year. Interim externalfinancial reportingprinciples impose a similar requirement wheninventoryis expected to be replaced by the end ofthe annualperiod.
- LIFO must be used infinancial statementsif it is elected for income tax purposes. However, forfinancial reportingpurposes, the lower of LIFO cost or market can be used without violating IRS LIFO conformity rules.
- Record keeping requirements under this method, as well as FIFO, are substantially greater than those under alternative costing and pricing methods.
- Inventories may be depleted due to unavailability of materials to the point of consuming inventories costed at older or perhaps the oldest prices. This situation will create a miss matching of current revenue and cost, sometimes companies using this costing method counteract this problem by establishing an allowance for replacement of the LIFOinventoryaccount. Cost of goods sold is charged with current cost. The allowance account is credited for the access of the current replacement cost over the LIFO carrying cost for theinventorytemporarily liquidated. When thisinventoryis replenished, the temporary allowance (credit) is removed and the goods acquired are placed ininventoryat their old last in first out cost.
- In standard number 411 “accounting for acquisition costs of materials, ” thecost accountingstandards board “CASB” precludes the use of LIFO except when applied currently on a specific identification basis. As a result, the use of this method, when an annual LIFO adjustment is made, is ruled out forgovernment contractsto which CASB regulations apply.
The decision to adopt the last in first out method has had increased appeal in the last few years, due to an accelerated rate ofinflation; however its adoption should not be automatic. Long range effects as well as short term benefits must be considered.