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Last In First Out Method (LIFO)

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Moneyzine Editor
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January 23rd, 2024
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Last In First Out Method (LIFO)

Definition

The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.

Explanation

Also referred to as LIFO, the last-in, first-out method assumes the newest items held in stock are the first items to be sold. This is an assumption used to value the company's inventory; the physical flow of items from inventory may differ from this valuation technique.

While this approach might seem counter-intuitive, there are strong arguments that support the LIFO method. Proponents of LIFO believe that income values should be based on current market costs. That is to say, current revenues should be aligned with current costs.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. It's also important to understand the ending inventory value for one year is the beginning inventory value in the following year. Inventory errors likewise have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

The following table illustrates the LIFO approach to valuing inventory. Company A begins the year with 250 units, adds 400 units throughout the year, and sells 500 units. The ending inventory for Company A is 150 units.

Units

Cost per Unit

Total Cost

Beginning Inventory

250

$700

$175,000

Additions on March 1

100

$725

$72,500

Additions on June 1

100

$750

$75,000

Additions on September 1

100

$775

$77,500

Additions on December 1

100

$800

$80,000

Goods Available for Sale

650

$480,000

Units Sold

500

Units from Beginning Inventory

150

$700

$105,000

Ending Inventory

150

$105,000

The above ending inventory of $105,000 can be used along with the cost of goods available for sale ($480,000) to determine the Cost of Goods Sold:

= Cost of Goods Available for Sale - Ending Inventory = $480,000 - $105,000, or $375,000

Related Terms

  • Inventory
    The financial accounting term inventory is used to describe the balance sheet line item that includes the value of raw materials, work in process, finished goods ready for sale, and returned goods that can be resold.
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  • First In First Out Method (FIFO)
    The financial accounting term first-in, first-out refers to one of several approaches to inventory valuation. The first-in, first-out method assumes the oldest items held in inventory are the first items to be sold when determining the value of inventory appearing on a company's balance sheet.
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  • Average Cost Method
    The financial accounting term average cost refers to one of several acceptable approaches to inventory valuation. The average cost method uses a weighted average approach to determine the value of inventory appearing on the company's balance sheet.
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  • Balance Sheet
    Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
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  • Assets
    The accounting term used to describe an economic resource, which is owned by the corporation and expected to provide future benefits to its operation, is asset. Appearing on the balance sheet, assets are typically broken down into two categories:
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  • Gross Profit Method
    The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.
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  • Lower of Cost or Market
    The financial accounting term lower of cost or market refers to an inventory valuation rule that states items should be valued at their original cost or their current market cost, whichever is lower.
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  • The financial accounting term retail method refers to an approach to valuing inventory in a retail business setting. The retail method assumes the relationship between the cost of goods in stores and their retail price is consistent in the current period.
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