LIFO Liquidation
LIFO liquidation is the situation which company uses LIFO cost method, but the sale quantity is higher and the cost of goods sold matches the current cost. In LIFO, the cost of inventory sold will base on the old purchase item, it is called the cost layer. But when the company sells a huge amount of stock, they will use all the items in the previous cost layer. As a result, the cost of inventory will equal the most recent purchase. It is when LIFO Liquidation happens.
LIFO, Last-in First-Out, is the method that we use to calculate the cost of goods sold based on the recent cost of inventory. The cost of stock, which is the last purchase, will be used to calculate the cost of goods sold. It is not related to the physical movement of the goods as it is almost impossible to track the actual inventory when we sell thousands of them. We use this method to calculate the cost of inventory sold and the valuation of the remaining stock.
This method can be used with the actual inventory as well. The company wants to get rid of the old inventory before it becomes obsolete or even written off. As we know the inventory will face a high risk of obsolete when they are kept in the warehouse for longer than usual time. When they stay for a certain period of time, they are highly likely to stay forever. The customers will be looking to purchase the new fresh stock even if the quality is similar. To solve this problem, the warehouse manager arranges the old stock and tries to sell them before they are too old. Some companies may provide discounts on the old stock to increase sales.
The company usually keeps some inventory in warehouse in order to prevent any shortage, and these inventories are known as inventory minimum level. The purchasing department will place the order when the inventory level is approaching this level. . It is the inventory level that company place order and receive material without disturbing the production process. It also helps to minimize the storage cost which incurs when company stores inventory more than it needs.
LIFO Liquidation happens when the stock level reaches this layer, the new purchase has not yet arrived, and the company needs to deliver the old stock to the customers. It is also known as the delayering old stock. The company sells inventory more than what they have purchased during the accounting period.
Impact of LIFO Liquidation on Financial Statements
As we already know, accountants use LIFO to determine the cost of goods sold and inventory valuation, so these two accounts will be impacted by LIFO method when the purchasing price of inventory changes.
LIFO Method When Price Increase
The suppliers may increase the price of inventory due to various reasons which will impact our cost. So what will happen to our financial report? Because of the LIFO method, the impact will take place immediately as the price increase. The cost of goods sold may increase in the current month, which will decrease the profit. On the other hand, there will be less impact on the inventory in the balance sheet or even no effect as it depends on the remaining stock left from the prior month.
For example, company A purchases the inventories from supplier P.
| Purchase Date | Description | Qty | Cost/unit | Amount |
|---|---|---|---|---|
| Jan | Item A | 1,000 | 10 | 10,000 |
| Feb | Item A | 2,000 | 10 | 20,000 |
| Mar | Item A | 2,000 | 12 | 24,000 |
| Total | 5,000 | 54,000 | ||
During March, the company sold 3,000 units of product A. Please calculate the Cost of goods sold at the end of the month by using LIFO.
As we use LIFO, the cost of goods sold will exceed the latest price which we bought from the supplier. The cost of 2,000 units sold will base on the current price and another 1,000 units base on the previous price.
Cost of goods sold = (2,000 units * $ 12/unit) + (1,000 units * $ 10) = $ 34,000
There are 2,000 units (5,000 units – 2,000 units) remaining at the end of the month, and they will value base on the old cost.
Inventory = (1,000 units * $ 10) + (1,000 units * $ 10) = $ 20,000
We can see that the cost of goods sold increase $ 4,000 just after the purchasing price increase, and it will decrease the profit significantly. It cost only $ 30,000 ( if the products sold in the prior month).
LIFO method When Price Decrease
The cost of inventory may be decreased due to the market condition, which also impacts our financial statements. The cost of goods will decrease immediately, which will increase the profit, while the inventory in the balance sheet may decrease or even stay the same base on the sale volume.
For example, let’s use the previous example, instead of the price increase in March, but it is decreased. Please refer to the following figure:
| Purchase Date | Description | Qty | Cost/unit | Amount |
|---|---|---|---|---|
| Jan | Item A | 1,000 | 10 | 10,000 |
| Feb | Item A | 2,000 | 10 | 20,000 |
| Mar | Item A | 2,000 | 8 | 16,000 |
| Total | 5,000 | 46,000 | ||
During March, the company has sold 3,000 units of product A. Please calculate the Cost of goods sold and at the end of the month by using LIFO.
As we use LIFO, the cost of goods sold will depend on latest price which we bought from the supplier. The cost of 3,000 units sold will base on the current price.
Cost of goods sold = (2,000 units * $ 8/unit) + (1,000 units * $10/unit) = $ 26,000
There are 2,000 units remaining at the end of the month, and they will value base on the old cost.
Inventory = (1,000 units * $ 10) + (1,000 units * $ 10) = $ 20,000
We can see that the cost of goods sold decrease $ 4,000 after the purchasing price decrease, and it will increase the profit significantly. It would cost $ 30,000 if the product was sold in the prior month.