In a LIFO system, the most recently acquired products are sold first—theoretically, anyway. Practically speaking, though, the LIFO method is mostly a way to determine which costs get applied to your most recent product sales.
With the LIFO method, you’d apply the costs from your most recent purchase orders to your most recent COGS, as illustrated in the example below.
The cost to buy your product can vary depending on the time of year, your supplier’s access to raw materials, the number of items you order, and tons of other factors. Consequently, most businesses pay a different cost per item each time they reorder inventory. The LIFO method helps you determine which costs to assign to your most recently sold goods.
So let’s say your business sells furniture, and you’re trying to figure out the COGS for kitchen tables during the past quarter. You take a look at your purchase history and see that during the quarter, you placed three new orders and bought 550 new tables, while you sold 400 tables during the same period.
In the table above, we’ve labeled each purchase order as a LIFO layer to help you see which entries apply to your COGS. Since the LIFO method depends on applying the most recent costs first, you would start with LIFO layer 4, then move on to LIFO layer 3.
You’ll also notice we’ve listed the business owner’s cost per item in the same column as the sales price per item. Though the sales price per item is not used in the COGS calculation, it is an important component of accounting. And we wanted to show how to find the business owner’s cost per item when listed alongside sales (as it likely would be in an accounting system).
If you applied the LIFO method using the table above, that would mean the most recent purchase costs would be applied to your sales for the quarter, like so:
As you can see, for each completed sale, we applied the costs for a LIFO layer. Since we’re using the last in, first out method, we used the most recent LIFO layer first (LIFO layer 4). Since LIFO layer 4 consisted of 250 items and the sale on October 9 was for only 150 items, the cost for the remaining 100 items from LIFO layer 4 were applied to the first 100 items on the next sale (on November 20).
In the end, though, the sold items were less than the number of purchased items, which means the costs of the starting inventory were never applied. However, the total cost of goods sold ($220,000) reflects the most current costs for running the business.