In this content you’ll find out what LIFO means, Last In First Out. Let’s see how it works. There are three of Cost Flow Assumption, FIFO, LIFO and AVCO. Today, I’m going to discuss a four step process to, calculate your cost of goods sold and closing inventory using LIFO. First, a quick reminder the basic inventory calculation looks like this. You have your opening inventory plus your additions which gives you your cost of goods available for sale and when you take away your cost of goods sold you get your closing inventory.
Inventory Cost Flow
When we discuss Inventory Cost Flow Assumptions, we’re trying to work out how much cost needs to flow in to cost of goods sold in your income statement, when you make a sale and on the flip side. How much cost should remain, where it is in your closing inventory in your balance sheet? Calculating this can be a bit tricky, if you pay different amounts for your inventory to begin with and that’s where Inventory Cost Flow Assumptions come in. These are some basic rules that help you estimate your cost flows. They don’t reflect the reality of underlying transactions. There are three Cost Flow Assumptions. FIFO, LIFO and AVCO First In First Out Last In First Out and the Average Cost Method. In this content, we’re going to cover LIFO. When you make a sale using the LIFO method you make the assumption that your newest inventory will be sold first.
Last In First Out (LIFO)
Last to come in first to go out. Time for an example we’re discussing the same one that we did in the FIFO which means, Squeegees! It’s the start of November and you have 220 squeegees in your inventory. These cost you two dollars each. On November 5th you buy another 400 squeegees for $1,200 and a few days later on November 12th. You sell 500 squeegees for $2,750. What’s your cost of goods sold and closing inventory for November assuming that you’re using the LIFO Cost Flow Assumption? Last In First Out. It’s time for some steps. We’ll go through them now but you can also get them on my Inventory Cost Flow Assumptions cheat sheet. If you’re finding these accounting tutorials at all helpful and you’d like to help support the channel then the best way you can do that is by buying one of my cheat sheets. You can find the link up here and down below as usual.
Draw an Inventory Cost Flow Table. This is a table made up of five columns… Date, description, quantity cost per unit and total cost.
Enter what you know. What do we know? On November 5th you went and bought another 400 squeegees costing you $1,200 in total. This belongs in the table as well. On November 5th, you added 400 units to your inventory which came to $1,200. In inventory cost flow tables you want to leave blank rows beneath each addition or sale. This gives you some room to put your goods available for sale which is a subtotal of the rows directly above it.
On November 12th, you sold 500 squeegees for $2,750. Now be careful here, this $2,750 is the revenue that you’ve earned not the cost of goods sold that you’ve incurred. So, it doesn’t belong in the inventory cost flow table. So on November 12th, you sold 500 units and that’s all we know about this transaction. We’ll need to work out your total cost of goods sold later. We’re also going to calculate your closing inventory on November 30th.
We need to fill in the blanks. We’ll begin by calculating the total cost of your opening inventory. You kicked off the month with 220 units, which cost you $2 per unit. 220 multiplied by $2 is $440. Next we’ll work out the cost per unit of your additions. You bought 400 units which cost you $1,200 in total. $1,200 divided by 400 units is $3 per unit. Now we can take some subtotals to work out your goods available for sale. 220 plus 400 is 620 units available for sale and 440 plus 1200 is $1640 your total cost of goods available for sale. When using the LIFO or FIFO, methods you can ignore the cost per unit of your goods available for sale goods sold and closing inventory. So, we can move on and calculate your total cost of goods sold.
You sold 500 units but what was the cost of goods sold, that you incurred in this transaction? Remember LIFO means Last In First Out. The last squeegees you bought were your additions of 400 units, which cost you $3 per unit but you still need to sell another 100 units to reach 500. The next hundred units come from your opening inventory, which cost you $2 per unit. So let’s work this out, 400 units multiplied by $3 is $1200 and 100 units multiplied by $2 is $200. The 1200 plus 200 is $1400 this is your total cost of goods sold. Great that’s the tough bit out of the way. Now, let’s find out your closing inventory on November 30th. To do that we need to take some totals. 620 minus 500 gives you 120 units and 1640 minus 1400 gives you $240.
Calculate your total cost of goods sold and your closing inventory. Your total cost of goods sold for the month can be calculated by adding up your cost of goods sold for every sell that you’ve made. In this example you only made one sale. So your total cost of goods sold for November is $1,400 and the total cost of your closing inventory is $240.
You can use these same four steps to solve any inventory cost problem. Now let’s have another look at the inventory calculation. Why would you choose LIFO over the other inventory cost flow assumptions? This method allows you to match your current revenues against your most recent cost of goods. So your gross profit reflects your business’s current performance. However when prices are rising during times of inflation your most recent cost of goods are also your highest, which gives you a higher cost of goods sold. Remember those squeegees in the example went from costing $2 per unit to $3 per unit? This gives you a lower gross profit, so when we compare your results using LIFO against the FIFO and AVCO methods. Your gross profit under LIFO comes in the lowest. But as a business owner, this can be a good thing. Businesses are charged tax on their profits. So lower profits means lower taxes, which can free up more cash for you to use in other areas of your business at least in the short term. But be careful, Last In First Out is not allowed under IFRS. So if you follow International Financial Reporting Standards, then you’ll need to use First In First Out or the Average Cost method instead. Next time we’ll cover the Average Cost method.