Inventory valuation methods: 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

• 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:

1. 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:
  1. 5 items from Opening Inventory (5-0)
  2. 3 items bought on 2 January (5-2)
  3. 0 items bought on 4 January ( 5-5)
  4. 5 items bought on 6 January (5-0)
• Thus the value of the closing inventory for the week is:

• 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