Cambrige AS and A Level Accounting Notes (9706)/ ZIMSEC Advanced Accounting Level Notes: Inventory valuation: Inventory valuation methods: Last In First Out (LIFO)
- As already pointed out in the introduction to inventory valuation methods
- There are several valuation methods that can be used to determine the cost value of inventory
- LIFO- Last in First Out is one of these methods
- Assumes that materials/inventories are issued out of inventory in the reverse order in which they were delivered into inventory
- The assumption is that the last items to be bought are the first to be used/sold and the first items to be bought are the last to be used or sold
- While this is not usually the case with most businesses there are instances where this can be actually true
- Consider the example of a flour milling business where the miller stores the wheat in silos or bins and the wheat is emptied from the top when it is end to the milling plant
- Or the case of a coal power generating plant such as Hwange Power Plant where coal is stored in bins which are emptied from the top
- In both instances the last coal batch to be bought is the first one to be used up
- This would also be true if the above were a wheat merchant who uses silos and a coal merchant who uses storage beans of the nature outlined above
- The first items to be sold would be the last ones to be purchased i.e. LIFO
| Cost of Sales/Used Inventory | Cost of closing inventory |
|---|---|
| For costing purposes, the latest items of inventory received are assumed to be the first ones sold/used | The cost of closing inventory is the cost of the earliest purchases of inventory. |
- The above are a summary of the assumptions of LIFO
- The assumption, to reiterate, is that the latest purchased items of inventory are used up first
- This leaves the business with the oldest inventory at the end of each period
- This results in the Cost of Sales being made up of the most up to date prices
Example
Itai has closing inventory of 5 units at a cost of $3.50 per unit at 31 December 20X7. During the first week of January 20X8, Itai entered into the following transactions:
- 2nd January – Bought 5 units at $4.00 per unit
- 4th January – Bought 5 units at $5.00 per unit
- 5th January – Sold 7 units at $10 per unit
- 6th January – Bought 5 units at $5.50 per unit
Required:
- Calculate the value of the closing inventory at the end of the first week using LIFO
Solution to Example
- We assume Itai sold the latest inventory items first:
- The first 5 items were taken from items from items bought on 4 January leaving a deficit of 2 items which were fulfilled by taking from the items bought on 2 January
- This leaves us with the following inventory:
- 5 items from Opening Inventory (5-0)
- 3 items bought on 2 January (5-2)
- 0 items bought on 4 January ( 5-5)
- 5 items bought on 6 January (5-0)
- Thus the value of the closing inventory for the week is:
| Date | Units | Cost/Unit ($) | Total Cost($) |
| 1 January | 5 | 3.50 | 17.50 |
| 2 January | 3 | 4.00 | 12.00 |
| 4 January | 0 | 5.00 | 0.00 |
| 7 January | 5 | 5.50 | 27.50 |
| Total | 13 | -- | 57.00 |
- As shown the items purchased last are considered sold/used first
- The above is a very simple example please click the links below to go to either the ZIMSEC Accounts Level page or the Cambridge AS/A Level page pages and select more examples on the topic
Advantages of LIFO
- Issue/Cost of Sales prices are up to date
- Prevents overstating of profits during times of rising prices i.e. it is more prudent
Disadvantages
- Not acceptable under the Companies Act and other laws of most countries
- Not acceptable under IAS 2
- Inventory values may become very out-of-date
- Cost comparisons become difficult even for similar jobs
To access more topics go the ZIMSEC Advanced Level Accounting page
To access more topics go to the Cambridge AS/A level page
