It is essential to have a proper understanding of how much to invest in inventory. This is primarily because the overall cost of an inventory significantly affects a business's profitability. Whenprices are spiralling down,businesses canconsider theLIFO method.
This article will explore a few important details of this accounting method. It will help you to have a better understanding of whether the LIFO accounting method is suitable for your business or not.
What is the LIFO Method?
LIFO stands for ‘Last-In-First-Out.’ It is amethod usedto calculate the valuation of inventory. As per the underlyingconcept of LIFO, thelatest items that getincluded in an inventory are the first to be sold at the beginning of an accounting year.
In other words, while calculating the cost of products, people usually evaluate the cost of those products which have been recently added to the inventory and record the result as COGS (Cost of Goods Sold). While creating a balance sheet for your company, you can add the costs of newer products first and leave out old inventory costs on the balance sheet.
How Does the LIFO Method Work?
It might be quite difficult to understand the LIFO accounting method. Suppose a business purchased 100 grinders at a per unit price of Rs.10 nearly a year before. Then, a week back, the business owner added another set of grinders to his inventory, priced at Rs.15 per unit. It’s natural for the business owner to want to sell off the second set at first. The LIFO accounting method enables him to do so.
When it’s time for the business owner tocalculate the inventory for tax purposes, they cancalculate the remaining stock at alower amount with the help ofLIFO. The main important reason behind this is the presence of disproportionately priced items in the inventory. As a result, the amount you have to pay as taxes is far less.
Where is the LIFO Method Used?
One can use the LIFO method in the United States of America (USA) since its usage is permitted only there. This method is uncommon in India due to tax restrictions and implications.
When Should the LIFO Method be Used?
LIFO, as mentioned above, is agood option if thecost of your inventory is expectedto go up in the future. It is a good option if you reside in the USA. If you undertake research about which companies use this method the most, you’ll find that gas and oil companies, car dealerships and retailers use it the most.
LIFO Method Formula
If you wish tocalculate COGSusing the LIFO methodof inventory valuation, you have to find out thecost of your latest inventory. Next, you have tomultiply it by theamount of inventory you havesold.
LIFO Method Examples
Let’s use a few examples to understand the LIFO method better:
Tina started a business which sold stationary items. However, it was not the best time to start a business because the cost of the items required to manufacture the stationary items had risen. Tina can apply the LIFO accounting method to help her business go through these trying times.
In other words, Tina should use the latest price paid for products while calculating.
COGS calculation would be as follows:
Number of goods x Cost of each good = COGS
20 x 200 = Rs.4,000
Tina is well aware that the price of supplies may increase further. So, she can calculate COGS with this lower number to get a tax break. Suppose Tina knows exactly how much the prices will increase in the next month. This lower amount will help her bring down the taxes payable at that time. It will greatly increase the savings of Tina’s business; however, it will bring down its profits.
Advantages and Disadvantages of LIFO Method
Advantages of LIFO method:
- Accurate valuation of current earnings
The LIFO method is responsible for understating profit and exaggerating COGS (Cost of Goods Sold). LIFO can help you get a better measurement of the current earnings of your business. Moreover, it helps to reduce inventory profits by aligning current business revenue with current costs.
- Improves cash flow and offers tax benefits
When you use the LIFO method during inflation, your high-cost purchases match with the revenues to make sure that business profits have not been overstated. It leads to a reduction in the cost of income tax and improves the cash flow of your business.
- Well-aligned with receiving process
There are cases when the LIFO method aligns perfectly with the inventory flow. Suppose the people responsible for inventory in a business store them vertically in a business. Upon receiving them, the last inventory stock would always be the first to be used.
Disadvantages of LIFO method
- Incompatibility with international standards
The LIFO valuation method is not compatible with the guidelines of International Financial Reporting Standards. So, it is not an accepted method under the taxation rules of many countries worldwide, including India. Another disadvantage is the risk that older objects lying in inventory might become obsolete.
- Higher taxes
When you use the LIFO method, it may exaggerate reported income for that particular period, which may increase the tax payable for the corresponding timeframe. Companies may end up buying more inventories to match their revenues and to avoid higher taxes. It might just lead businesses to adopt unhealthy business habits under the LIFO method.
- Misleading data
When you use the LIFO method, your inventory will be understated in the balance sheet. This is because its valuation will be based on the older costs. In other words, your working capital position may not look very attractive.
- Greatly impacted by inflation
Using the LIFO method during inflation reduces revenue. It might have a negative impact on the investment and stock price of the company. Moreover, this method is not very easy to understand. Many investors struggle to comprehend the complexities of LIFO and the overall impact of using it for calculating the revenue of a business.
Conclusion
If you are a business owner based in the USA, you should be aware of LIFO (last-in-first-out). The most noteworthy feature of the LIFO method is that it brings down the profit margin, which, in turn, brings down taxable income. But, before using it, you should remember that applying for credit will become difficult if you have a lower profit margin.
