Working out the cost of goods sold is an important step to valuing inventory, and has implications for a business’s balance sheet and its tax assessment. When an accountant calculates the cost of goods sold, they use a cost-flow assumption to convert the varying costs of acquiring the business’s inventory to the cost of the goods sold. Last-In, First-Out (LIFO) is one of the three most used cost-flow assumptions.
The reason that LIFO is often called an assumption is because the specific costs that flow out of the inventory do not necessarily map directly to the particular units of product which are being shipped. If a bottling plant produces a homogenous product such as bottles of sparkling ale, cases of ale produced at different points during the financial year might have different costs of production. Yet by looking at one of the many cases of ale being shipped out of the brewery’s warehouse it would potentially be difficult to determine exactly which set of production costs were incurred in making that particular case of beer. LIFO is a rule that resolves this ambiguity – in the situation where costs can’t be specifically identified, and where the inventory is not entirely exhausted, LIFO tells us how to determine which costs of production are allocated to the cost of goods sold.
When a business calculates the cost of goods sold using LIFO, the costs of production of the most recently produced or purchased inventory are counted first when counting the cost of goods sold. The effect is that the value of inventory is a function of the cost of production of the oldest goods. If a business produces 100,000 units of product, but only sells 80,000 units, under LIFO the business will determine the cost of goods sold by adding up the cost of production of the more recently produced 80,000 units. Likewise, the value of inventory is the cost of production of the remaining 20,000 units.
Cost of Production – Cost of Goods Sold = Value of Ending Inventory
LIFO is more desirable for some businesses for both accounting and taxation reasons. Firstly, using LIFO means that on-book profitability is a function of the most recent costs, which gives a more accurate sense of how the business is presently performing. Secondly, if costs increase over time due to inflation, the most recent costs are also, generally speaking, the highest – this reduces a business’s assessable income, and therefore also its income tax bill.
Unfortunately, the LIFO method is not available to businesses in a number of markets around the world. Because calculating the cost of goods sold using LIFO can reduce a business’s tax liability, most Governments do not allow the LIFO method to be used. An important exception is the United States, whose income tax rules do permit the use of the LIFO method. Be sure to get legal advice or talk to your accountant or taxation adviser if you’re considering using the LIFO assumption to calculate the cost of goods sold.