LIFO Inventory Method

In this video we're going to talk about LIFO, which is an Inventory Cost Assumption that's short for Last In First Out. Actually, we've got a similar process to LIFO. If you just watched our LIFO video, this will be very easy for you to understand. But just to give you an idea, let's say, let's use an example here. You have a firm that sells t-shirts. Let's say you sell 250 t-shirts at your company. And they're all the same type of t-shirt. They look exactly the same. There's just 250 of them. So when you sell these t-shirts, you have to say, okay, well, what's my cost of goods sold and what's going to be my ending inventory? Now you might be wondering, okay, well, why is this necessary? You just bought the t-shirts and now you're selling them. Well, you might have made several different purchases of the t-shirts. You might have bought some one day and then another day you bought some more t-shirts and then you bought more. And you just kept throwing them all into one big pile in the corner of your store. So now you've got this pile of t-shirts and now you haven't sold all of them. You just sold 250. And so you're trying to wonder, okay, out of this pile of t-shirts, which ones go to ending inventory and which ones go to cost of goods sold? Because you might have paid different prices for them even though they're the same t-shirts. So let's walk through an example of how we'd use LIFO to compute cost of goods sold in our ending inventory. So let's say that when we sell those 250 t-shirts, so let's say we sell them on May 1st. May 1st we sell 250 shirts and now what do we need to know? We need to know COGS, cost of goods sold, and we need to know ending inventory. I'll just have EI. So here are the purchases, right? So this is the purchases. We go and we take a look at the books and we say, okay, what's our purchase history with these t-shirts? And we see that on March 1st we bought 200 t-shirts at a price of $10 a shirt for a total of $2,000. Now on March 16th we bought 150 shirts for $12 a piece. And then on April 3rd we bought another 225 shirts for $16 a pop. So now we don't know of the 250 that we sold, we don't know, okay, this one was from the March 16th purchase because we've just been throwing them into that pile. So now we have to make an assumption about which of these units, from which dates, with which prices are going to go on the cost of goods sold and which are going to be in our ending inventory. And we're making an assumption, and in this case we're going to assume last in, first out, LIFO. And what does that mean? That means that when we're talking about our cost of goods sold, the last units in, the most recent purchases, are going to be the ones that go to cost of goods sold. So this 225, those 225 units that we purchased, those are the most recent units that we purchased. So they're going to go to cost of goods sold. So we're going to have 225 units here. But you see we sold 250, so we still have another 25. And where does that come from? Well, it's going to come from right here. We purchased, the next most recent was March 16th, so the 25 will come out of here. I'll just put a little 25 there, and those are also going to go to cost of goods sold. So now let's compute our cost of goods sold. Well, we've got the 225 times the 16. That's definitely going to be in there. And then we also have the 25 units here, so that we get to 250. So those 25, and what price did they go at? Well, that was $12 a piece. So now we've got this little equation here, right here. This is going to be our cost of goods sold. So we're going to have, actually the top is going to be 3600, that's this part right here. And then the bottom, the 25 times 12 is 300. But now we have to add those two together, and we get 3900. So our cost of goods sold is $3900. Now we have to compute our ending inventory. I'll just put it here. I'll just abbreviate this EI, our ending inventory. And now we just kind of do the reverse. So we say, okay, well, we didn't touch these 200 units here. So those 200 units are still going to be in our inventory. So we're going to have 200, and that's going to be multiplied by the $10 price that we paid for them. And then we're going to have another 125 units. And you say, well, why 125? Well, remember we have 150 in this original purchase, but we already took out 25. It went to cost of goods sold, remember? So 150 minus 25 is 125. So we've got 125 units there that didn't go to cost of goods sold. And what's the price? Well, it was $12 a shirt. So that's going to be $12. And so that's going to give us, on top, this top portion is going to be 2000. And then we add to that the bottom, 125 times $12, which is 1500. And now we add these two together, and that gives us $3500. And that's our ending inventory. Now, bear in mind that LIFO is better at matching costs with sales with revenue in periods of rising prices, which is usually the case in the real world, and it's what we have here in this example. Look, over time, the price we pay for units, for t-shirts, is going up. So when we have LIFO, what we're doing is we're taking the most recent cost, which is probably the most relevant cost, what we had to pay last week, instead of what we had to pay a month or so ago or two. So we're taking that more recent cost, and that's actually more likely to go to cost of goods sold, and so we're matching that with our current sales. So it's better with matching, but there's a problem, and that's that LIFO, when we keep taking goods out of the most recent purchases, well, sometimes we get these ones that are from a couple months ago that are ending up in ending inventory, and over time, you might have something that five, six, seven years ago, you had these purchases, and they're still in inventory, because you've got a LIFO that keeps taking the most recent goods out. And so what happens is, when you have some case like, for example, a railroad or something that has some kind of inventory from 1874, and then they go and sell it, well, then you're going to have a really low cost being matched with your current revenue, and actually, that's kind of a problem. And you call those old inventory buildups, you call those, those are actually LIFO layers, right? So it's like this old layer of inventory that hasn't been liquidated, and then all of a sudden you go and you sell it, and then now you have to, it finally goes to cost of goods sold, and there's kind of this mismatching of what you sold the items for versus what you paid, and so that's actually a thing called LIFO liquidation, which we're going to talk about in another video.