Businesses that sell products must value these products when they file their income taxes. There are many IRS-approved methods to value your inventory.
One of these inventory valuation methods is called Last In, First Out (LIFO). This method assumes that inventory items are first sold in an accounting year.
Methods for Inventory Valuation
Your business inventory which includes products, parts, and materials is a valuable asset. Costs associated with manufacturing, purchasing, maintaining, and shipping inventory can be costly business expenses. You need to be able to identify and assign a value to your inventory.
Calculating the Cost of Goods Sold
The inventory at year’s end determines the cost of goods sold (COGS). This information will be included in your business tax return. To calculate your gross profit for the calendar year, COGS is taken from your gross receipts (before any expenses).
Calculating COGS is as easy as:
- At the beginning of each year, count the inventory
- Addition of purchases, labor costs, and other costs
- Addition of inventory at the end.
How LIFO Inventory Costing Works
There are many options available to determine the cost of inventory when you use the COGS calculation. These are the three most common methods to value inventory:
- Specific ID: This is for inventory types where you can match the cost of the items (e.g. a car with the Vehicle ID Number).
- LIFO – This method assumes the items you purchased or manufactured LAST are the first items that you sell, consume or dispose of
- First in, first-out (FIFO): You, as a business owner, assume that the items you bought or made first will be the first items that you sell, consume or dispose of.
You can group items using the LIFO cost method to make it easier to count them. This is done by following one of the IRS-approved guidelines. These are two of the rules to value LIFO:
- Dollar-value is a method in which products are classified based on their types.
- The simplified dollar-value approach, with multiple inventory classes within general categories.
A simple example of LIFO calculation
Let’s say that a product is produced in three batches over a year. These are the costs and quantities of each batch, in order of when they were produced.
- Batch 1: Quantity 2000 pieces, production cost $8,000
- Batch 2: 1,500 pieces. Production cost $7,000
- Batch 3: 1,700 pieces. Production cost $7,700
Total produced: 5,200 pieces. The total cost was $22,700. The average cost of producing one-piece is $4.37
Next, calculate unit costs for each batch.
- Batch 1: $8,000/2,000 = 4
- Batch 2: $7,000/1.500 = $4.67
- Batch 3: $7.700/1.700 = $4.53
Under LIFO accounting, to determine the cost of units, you assume that you have sold all the items produced in the last year. Then you work backward.
Let’s assume that 4,000 units were sold in the year. You can assume that Batch 3 was sold first using LIFO. The first 1,700 units of the last batch were sold at $4.53 each. This is a total cost of $7,701.
- Batch 2 sold 1,500 more units for $4.67 each, which equates to $7,005.
- The last 800 units were sold starting in Batch 1 at $4 each for a total cost of $3,200.
- The 4000 sold items cost $17,906.
For a total cost of $4,800, the remaining 1200 units will be $4 each. These units will be available for purchase starting in the next year.
LIFO vs. FIFO
FIFO assumes the first batch of items will be sold first. Assuming that 4,000 units were sold, let’s use the above example.
All 2,000 Batch 1 items are valued at $4.00 each. Total $8,000.
Next, 1,500 Batch 2 items will be counted at $4.67 per each. Total $7,000.
Finally, 500 Batch 3 items are counted at $4.53 per, a total of $2.265.
- The total cost of FIFO is $17.265.
- Under LIFO, the total inventory cost was $17 906.
The remaining items cost $5,436 under FIFO, while the cost under LIFO is $4,800.
Choosing to use the LIFO Method
FIFO inventory costing is the default; you have to choose LIFO if you wish to change. You cannot go back to FIFO after you have adopted the LIFO method.
To change to LIFO you will need to complete and file Form 970. You must file the form along with your tax return for that year you used LIFO.
You will need to complete the election application
- Please specify the goods for which the LIFO method is applicable.
- Please identify and describe the inventory methods you used to value these goods in the previous year.
- Describe the goods for which the LIFO method is NOT applicable.
Also, you must give detailed information about the costing methods or methods that you will use with LIFO (the specific goods, dollar value, or other approved method).