What is the LIFO method?

With the LIFO method, goods that were last added to inventory are withdrawn first. The LIFO principle can also play a role in ac­count­ing for a company’s assets.

What is LIFO?

The LIFO principle is a procedure from inventory man­age­ment which states that goods that were last added to an inventory are withdrawn first. LIFO stands for ‘last in, first out’. Since the LIFO method also plays a role in the valuation and taxation of goods, it is par­tic­u­larly important for the stock control systems of online shops. Companies should also carefully develop systems for supply chain man­age­ment and their dis­tri­bu­tion channels. Although LIFO can be used by companies that do not have a warehouse strategy, this is usually not re­com­men­ded.

How does the LIFO method work?

To get a better idea of how the LIFO method works, let’s look at an example from everyday life. Imagine you’ve just bought a new shirt and want to store it in your closet. You neatly fold it and place it on top of a pile with your other shirts. The next day, you take out your new shirt from the top of the stack, and the rest of the ‘stock’ remains untouched. This same principle is also used in mer­chand­ise man­age­ment: new items are po­si­tioned in such a way that they can be retrieved first. The opposite of LIFO is the FIFO method (first in, first out).

What do you need to consider before im­ple­ment­ing the LIFO method?

Before im­ple­ment­ing the LIFO method, you first have to consider the nature of the goods you are dealing with. LIFO is not re­com­men­ded for products that have an ex­pir­a­tion date, can be damaged by prolonged storage, lose value over a longer period or are tied to a current trend. On the other hand, if the stored goods are durable and don’t need to be dis­trib­uted in any par­tic­u­lar order, LIFO is re­l­at­ively easy to implement. Goods can be stored in a storeroom, in open spaces or pits, in high racks or per­man­ently bolted to the wall. However, the LIFO method can make it difficult to keep track of your inventory.

What are the ad­vant­ages of the LIFO method?

If your warehouse and the nature of your goods are com­pat­ible with the last-in, first-out method, the system can provide you with several ad­vant­ages. Due to its sim­pli­city, new employees can stock the warehouse without any special training needed. This shortens or­gan­iz­a­tion­al times con­sid­er­ably and reduces the number of employees needed to remove and stock goods. Distances are shorter, and with the op­tim­iz­a­tion of storage space, storage costs can also be reduced. With LIFO, you can store older goods long term, and you don’t need to invest in an expensive, free-standing shelving system.

How is inventory evaluated with LIFO?

LIFO doesn’t just play a role in warehouse man­age­ment. The LIFO method can also be used to value your company’s assets. It is used both in com­mer­cial law and in tax law.

LIFO in com­mer­cial and tax law

In the UK, companies value their inventory in ac­cord­ance with the Financial Reporting Standard 102 (FRC 102), which is based on In­ter­na­tion­al Financial Reporting Standards (IFRS). Most countries through­out the world adhere to the IFRS and under both the IFRS and the FRC 102, LIFO is not permitted. Ac­cept­able valuation methods for taxation purposes include FIFO, specific iden­ti­fic­a­tion and average cost.

What are the LIFO methods?

LIFO uses two different methods to carry out cal­cu­la­tions: the permanent method and the periodic method. In both cases, the lowest value principle applies. This means that assets may never be recorded in the balance sheet at a value that is too high. If lower values can be de­term­ined, these must be used instead. All values on the reporting date are compared with current market values of a commodity and the lower value is applied.

Dollar-value LIFO

Dollar-value LIFO is a variation of the LIFO method that tracks changes in inventory values based on changes in prices, rather than the physical units of inventory. If the prices of goods increase, the dollar value of the inventory will also increase, even if the quantity remains the same.

The perpetual LIFO principle

In the perpetual LIFO method, additions and disposals are recorded con­tinu­ously through­out the entire period. Although this LIFO principle is very accurate, it is time-consuming, which is why it is rarely used in practice. Here, we will use an example to show how the perpetual method of LIFO works. Let’s imagine a candy company that needs to purchase sugar for its pro­duc­tion. A sim­pli­fied version of their annual balance sheet looks like this:

The first delivery took place on May 1. Using LIFO, the supply from February 1 is taken first. However, since ad­di­tion­al product was needed to fill the order, an ad­di­tion­al 10 kg was taken from the initial supply. This means that 100 kg are cal­cu­lated at the purchase price of £1 and 10 kg at the price of £2. This results in a total value of £120. The second goods issue uses the July 1 supply, where the cost was £4. However, since more than the supplied 150 kg was needed, another 50 kg was used from the initial stock. The cost of sold goods (COGS) for the second delivery amounts to £700.

Since the supplies were com­pletely used up, the sugar that is left at the end comes entirely from the initial supply that was recorded in January. To calculate the ending inventory, multiply the remaining 140 kg by the initial value of £2, giving you £280. To determine material costs, the two goods issues are added together: £120 + £700 = £820.

The periodic LIFO principle

The periodic LIFO method works a little dif­fer­ently. Here, only the ending inventory is recorded and mul­ti­plied by the price of the opening inventory. This sim­pli­fies the cal­cu­la­tion. Using the LIFO approach, it is assumed that the stock that was last delivered has already left the warehouse. Taking the data from the example above, the cal­cu­la­tion using the periodic LIFO principle would look like this:

The closing inventory is cal­cu­lated according to the opening inventory. In this case, this means that 140 kg are mul­ti­plied by £2, which equals £280. To calculate the cost of materials, use the following formula:

Opening inventory + goods receipts - closing inventory

In this case, this means: (200 kg x £2) + (100 kg x £1) + (150 kg x £4) - £280 = £820. To determine the value for in­di­vidu­al issues, add all the good issues together, take the remaining inventory and divide it by the sum of the good issues. In this example, this would be £820 divided by 310 kg This results in ap­prox­im­ately £2.65/kg.