Question

Explain how the last-in, first-out inventory method is applied.

Answer 1

This method assumes that the inventory which has been purchased recently are sold first and the cost of these inventory are expensed first. Under this method the older inventory is reported as ending or closing inventory. LIFO method is used to defer the taxation liability because with the passage of time the cost of inventory gets inflated and in LIFO method the recent purchases are expensed off in the profit and loss account causing an increased COGS expense for the current year. All the old inventory which is purchased at the lower cost are shown as ending inventory this reduces the profitability.

The above explanation can be understood with the help of following example:
Beginning Inventory = 20 @ 20 per unit
Purchases made
i) March '3 = 5 units @ 22 per unit
ii) March' 10 = 8 units @ 23 per unit
iii) March' 13 = 6 units @ 25 per unit
Sales
i) March 12 = 15 Units @ 30 per unit
i) March 25 = 10 Units @ 31 per unit
Compute Cost of Goods sold as on March 31 and Ending inventory under LIFO method

LIFO
	Units	Cost Per unit	Total
Beginning Inventory as on March 1	20	20	400
Purchases
March ' 3	5	22	110
March ' 10	8	23	184
March ' 13	6	25	150
Goods available for sale			844
Cost of Goods sold
March' 29
Units from March 13 purchase	6	25	150
Units from March 10 purchase	8	23	184
Units from March 3 purchase	5	22	110
Units from beginning inventory	6	20	120
Total Cost of Goods Sold			564
Ending Inventory (i.e. from beginning inventory)	14		280

In the above example it can be understood that the most recent purchases of the inventory are expensed off first
There are certain Advantages of LIFO:
a) In infaltion there is tax benefit because the inflated inventory are expensed off first
b) There are less chances of writing down the inventory because the most recent purchases are expensed off first
c) It can easily be understood
Disadvantages of LIFO:
i) There is more clerical/ manual work in this method
ii) It can result in understatement of inventory