What Is a LIFO Liquidation?
A LIFO liquidation occurs when a company employing the last-in, first-out (LIFO) inventory costing method begins to sell off its newest inventory first. It typically happens when current sales surpass current purchases, prompting the company to dip into inventory accumulated in previous periods.
Key Takeaways
- LIFO liquidation involves the selling of the most recently purchased inventory first.
- It’s an accounting method known as last-in, first-out (LIFO).
- This approach pairs the most recent costs with current revenues.
- Companies often employ LIFO during inflationary periods when inventory costs are rising.
How a LIFO Liquidation Works
The LIFO method emphasizes selling inventory that was most recently acquired. This tactic aligns the latest inventory costs with corresponding revenues. In periods of rising prices, companies can utilize LIFO to their advantage by reducing taxable profits—higher replacement costs seemingly counterbalance profits, reducing the tax burden.
LIFO Liquidation Example
Consider ABC Company, which follows the LIFO inventory accounting method for its local outlets. Here’s the company’s acquisition timeline over three years for a product it sells for $50 each:
Acquisitions:
- Year 1: 1,000,000 units at $10 each
- Year 2: 1,000,000 units at $12 each
- Year 3: 1,000,000 units at $14 each
- Year 4: Only 500,000 units at $15 each (due to an initial forecast)
After consistent sales of 500,000 units each year for the first three years, ABC Company’s remaining inventory totals 1.5 million units. An unexpected surge in demand prompts them to sell 1 million units in year four.
Year 4 Inventory Breakdown:
| Year of Purchase | Cost per unit | Quantity | Total Cost |
|---|---|---|---|
| 1 | $10 | 1,000,000 | $10,000,000 |
| 2 | $12 | 1,000,000 | $12,000,000 |
| 3 | $14 | 1,000,000 | $14,000,000 |
| 4 | $15 | 500,000 | $7,500,000 |
Revenue Generation in Year 4:
- 500,000 units from Year 4:
- Sold at: $25 million
- COGS: $7.5 million
- Gross Profit: $17.5 million
- 500,000 units from Year 3:
- Sold at: $25 million
- COGS: $7 million
- Gross Profit: $18 million
Inventory Status:
| Cost Year | Quantity sold | Quantity Remaining | Cost/unit | COGS | Gross Profit (Revenues - COGS) |
|---|---|---|---|---|---|
| 4 | 500,000 | 0 | $15 | $7,500,000 | $17,500,000 |
| 3 | 500,000 | 500,000 | $14 | $7,000,000 | $18,000,000 |
| 2 | 0 | 500,000 | $12 | – | |
| 1 | 0 | 500,000 | $10 | – |
Related Terms: FIFO, inventory turnover, cost of goods sold, revenue, taxation strategy.
