LIFO Reserve
Categories: Accounting, Company Management
See: LIFO.
A place set aside for all the LIFOs to roam free. Okay, maybe not.
There are two basic ways companies account for their inventories: FIFO and LIFO. FIFO stands for "First In, First Out." LIFO stands for "Last In, First Out." (We here at Shmoop take a LIFO attitude to coming to work on Fridays.)
FIFO assumes that any item sold to a customer was the oldest peice of inventory in stock. It came into the warehouse first, so it was the first thing sent out.
LIFO makes the opposite assumption. Anything sold was the most recent item made. Products basically go from factory floor to customer. Anything left in the warehouse is the oldest inventory around.
The difference between LIFO and FIFO accounting comes down to the cost of producing a product.
You run a factory that makes designer salad tongs. In May, it cost an average of $12.25 to make one unit. In June, it cost $12.32.
If you make a sale at the end of June, FIFO would assume that the product you sold to the customer cost $12.25. The items made during May were the first product "in," therefore the first to go out.
LIFO would assume the tongs cost $12.32. They were the most recently made items (the last ones "in"), therefore the ones that went to customers first.
The decision between LIFO and FIFO matters in computing margins and profits and, eventually, tax liability. The different cost basis for each situation leads to different results for the various computations that go into making financial statements.
If you sell a tong to the public for $35, the gross profit for the May-produced items is $22.75 ($35 - $12.25). The gross profit for those manufactured in June is slightly less, at $22.68 ($35 - $12.32).
Now, a little economic truism: prices and costs usually trend upward over time. You've probably heard your grandparents talk about how a trip to the movies used to cost $2.50 and you could buy a new car for $5,000. The reason you can't get those prices anymore is because of inflation. Prices generally drift higher over time. As such, FIFO costs tend to be lower than LIFO. Since costs are constantly rising (on average), the "first in" products will have been cheaper to make than the "last in" products. You know, the $12.25 salad tongs vs. the $12.32 ones.
The LIFO reserve is an account that closes the gap between the two accounting methods. In the salad tong example, the LIFO reserve would be $0.07 per tong produced...the difference between $12.25 and $12.32. If you made 100,000 tongs during a financial period, with a $0.07 gap, you'd record a LIFO reserve of $7,000.
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Finance: What is LIFO v FIFO?4 Views
Finance Allah Shmoop What is life Oh versus Fife Oh
All right Well this videos everything you wanted to know
about how to count inventory but were afraid to ask
if you really were afraid Well might we suggest a
visit soon to the Wizard Yes Soon Team life O
wants inventory to be counted based on the most recent
prices in the market place that's life O as in
last in First out So there is a war It's
not in the White House It's not China It's not
in the Middle East It's in the hallowed halls of
accounting firms everywhere Life Oh refers to inventory cost accounting
such that it counts the cost of the most recent
inventory acquired as the expense against revenues rather than the
first inventory acquired on what does all that mean All
right well let's look at Silly Putty a product vital
to the American psyche and built largely from highly volatile
Lee priced petroleum products All right Luckily for the sellers
of the Putty it last male almost forever And so
life O V Fi Foh becomes a big deal for
the putty they bought three years ago In the massive
shelf stocking exercise of two thousand sixteen The sellers of
party were paying two dollars an egg all in for
that product inventory But then three years later in our
current era after the great Somalian warlord rebellion had petroleum
costs skyrocketing such that the cost of the putty inside
that egg went from two bucks Tow three box and
they're still selling the putty thing there for five bucks
each right So life Oh style accounting would claim that
the expenses mapped against the five dollars per egg revenues
would be the last in egg prices Or that three
dollars and egg inventory unit cost showing a gross profit
of two dollars Had the company been using Ah fife
Oh style of accounting Well then they would have looked
to the three year old cost of a two dollar
an egg inventory cost and they would be showing a
three dollars per egg gross profit Yet another player in
the accounting Octagon That's what that looks like is what's
called the average cost of inventory calculation Where in well
here that average cost might be answer to fifty and
egg which would then give Ah fifty percent gross margin
or profit per egg sail on a five dollars selling
price of two Fifty Well why does all this matter
Well a few things heir issue here showing higher expenses
on the inventory shows lower accounting profit to the company
and it is on that operating profit that the company
is then taxed So if the company is able to
show less profits well then it simply pays less in
taxes But if the company is publicly traded well then
shareholders of the company I either owners likely get punished
in the public markets in the form of a lower
stock price at least for a while Because instead of
trading at twenty times earnings of three dollars twelve cents
a share or sixty two dollars in change the company
using the higher inventory cost now to show lower profits
well on Lee shows profits or earnings of two eighty
a share Still likely trading at that twenty times earnings
number for a fifty six ish dollars a share trading
price or roughly nine ish percent discount to where they
were trading Otherwise it's not quite that simple but that's
the idea In theory there are other adjustments that need
to get made on the company's balance sheet Then as
Well that is if the value of their inventory has
gone up some fifty percent and that inventory comprises a
meaningful amount of asset value to the company like you
know in the But he's going off from two to
three bucks Well then the decision is whether that inventory
should be held at market value I eat the new
higher price three dollars an egg putty or at the
acquisition cost i e The historical Three years ago two
dollars per egg putty For the old units that were
acquired a more middle of the road number would be
just that average cost thing at two fifty or average
adjusted book value Cost these numbers in a vacuum don't
mean a whole lot But in a highly volatile industry
like this one or rather industries with highly volatile expense
input the FIFA Life Oh smackdown can have huge changes
in reported company profits depending on which gets applied Think
airlines where fuel costs can run anywhere from twenty thirty
forty fifty send in the cost of running the airline
and in areas where fuel prices can double or triple
in a heartbeat and or get cut in half in
a year or less Well you can imagine that the
reported earnings numbers would be a harder to wrestle down
then Well this guy