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How to calculate LIFO and FIFO?

How to calculate LIFO and FIFO?

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Expert Solution

Last in First Out (LIFO)

Under this method, the material last purchased will be issued and used first. Therefore, under this method the price of the last batch (lot) is used for pricing the issues, until it is exhausted, and so on. This method is best suitable in inflationary situation when the prices of materials are going on rise. LIFO helps to ensure that the cost of production determined on the above basis is approximately at the current price.

First-in-First out Method (FIFO)

Under this method of inventory costing, material used are priced in the order in which they are purchased. In the due course of business, materials are purchased at different interval of time. Similarly, purchased materials are used at different point of time in different slots and different interval. Thus, the material that was first purchased is used first and subsequently the materials longer in stocks are used first.

Inflation is one of the major causes for inventory profit if FIFO method of inventory system is used. In contrast to it, LIFO method of inventory system gives lower profit.

The LIFO helps in reducing the inventory profits by matching the most recent costs against revenues. It results in reduction of understatement of cost of goods sold (COGS) and overstatement of profit. Therefore the quality and reliability of earnings are improved under LIFO. It can be understood with a simple example. Let us suppose, a set of inventory was purchased at $100 one month ago. Currently the cost of same set of inventory if $120. If we use FIFO method then we will derive the profit by subtracting the oldest inventory cost of $100 from the revenue. If the revenue is $150 then obviously the profit would be $50. If we use LIFO method, then we will take the latest inventory cost of $120 to match the current revenue and therefore, the profit will reduce to $150 - $120 = $30. Thus, if all other items of P&L account remain constant then LIFO method reduces the profit. In our case profit reduces from $50 to $30.

jeff jeffy answered 2 years ago
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