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Last In First Out (LIFO) - Materials and Inventory Costing Method:

Learning Objectives:

1. Define and explain last in first out (LIFO) method.
2. Give an example of LIFO costing method
3. What are advantages and disadvantages of LIFO method?

1. Definition and explanation of LIFO method
2. Example of LIFO costing method
3. Advantages of Last in First Out method
4. Disadvantages of Last in First Out Method

Definition and explanation:

The last in first out (LIFO) method of 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.

Under LIFO procedures, the objective is to charge the cost of current purchases to work in process or other operating expenses and to leave the oldest costs in the inventory. Several alternatives can be used to apply the LIFO method. Each procedure results in different costs for materials issued and the ending inventory, 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:

Calculations for the above transactions would be as follows

LIFO COSTING METHOD

The basic difference between the various applications of this costing method is the time interval between inventory computations. In this example of LIFO costing a new inventory balance is computed after each receipt and each issue of materials, with the ending inventory consisting 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 ending inventory from the total of the opening balance plus the receipts, the ending inventory would consist of:

Both procedures are appropriate applications of the LIFO method, even though the cost of materials used and the ending inventory figures differ. Such a difference does not occur in FIFO 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 to work in process from 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.

Unrealized inventory gains 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 a cash advantage through deferral of income tax payments. The tax deferral creates additional working capital as long as the economy continues to experience an annual inflation rate increase.

Disadvantages of the LIFO Costing Method:

The disadvantages or limitations of the last in first out costing method are:

1. 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 the Internal Revenue Service (IRS)
2. 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, the business would be at a tax disadvantage. When prices drop the only option may be to charge off the older (higher) cost by liquidating the inventory, 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 the inventory returns to its original level at the end of the year. Interim external financial reporting principles impose a similar requirement when inventory is expected to be replaced by the end of the annual period.
3. LIFO must be used in financial statements if it is elected for income tax purposes. However, for financial reporting purposes, the lower of LIFO cost or market can be used without violating IRS LIFO conformity rules.
4. Record keeping requirements under this method, as well as FIFO, are substantially greater than those under alternative costing and pricing methods.
5. 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 LIFO inventory account. 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 the inventory temporarily liquidated. When this inventory is replenished, the temporary allowance (credit) is removed and the goods acquired are placed in inventory at their old last in first out cost.
6. In standard number 411 "accounting for acquisition costs of materials, " the cost accounting standards 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 for government contracts to 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 of inflation; however its adoption should not be automatic. Long range effects as well as short term benefits must be considered.

You may also be interested in other useful articles from "controlling and costing materials" chapter:

1. Purchases of productive material
2. Purchases of supplies, services, and repairs
3. Materials purchasing forms
4. Receiving materials
5. Invoice approval and data processing
6. Correcting invoices
7. Electronic data processing (EDP)  for materials received and issued
8. Cost of acquiring materials
9. Storage and use of materials
10. Issuing and costing materials into production
11. Materials ledger card - perpetual inventory
12. First-in-First-Out (FIFO) Costing Method
13. Average Costing Method
14. Last-in-First-Out (LIFO) Costing Method
15. Other Methods-Month end average cost, last purchase price or market price at date of issue, and standard cost
16. Inventory valuation at cost or market whichever is lower
17. American Institute of Certified Public Accountant (AICPA) cost or market rules
18. Adjustments for departures from the costing method used
19. Inventory pricing and interim financial reporting
20. Transfer of materials cost to finished production
21. Physical inventory
22. Adjusting Materials Ledger Cards and Accounts to Conform to Inventory Accounts
23. Scrap and waste
24. Spoiled goods
25. Defective work
26. Discussion Questions and Answers about Controlling and Costing Materials

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