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    LIFO

    The cost flow method ‘last in, first out,’ otherwise known as LIFO, charges the most recent purchase costs to costs of goods sold. Similarly, older costs are assigned to ending inventory (ie. 'first in, still here').

    LIFO works well when it truly matches the actual physical flow of goods. For example, imagine a hardware store that has buckets of screws for sale. When it purchases new inventory, new screws may be thrown on top of the old screws. Customers would then purchase newer inventory first, and old inventory will typically stay at the bottom of the bucket. 

    One advantage of LIFO is that it does a good job of matching the company's most recent costs with current revenue. As well, ending inventory values under LIFO are ordinarily lower than under FIFO, and are usually lower than net realizable value. As a result, company's that use LIFO rarely have to write down inventories in the event of a price decline; FIFO costs are more vulnerable to price declines, which can substantially reduce net income. 

    Disadvantages of LIFO include reduced earnings, inventory distortion, physical flow, inventory liquidation, and poor buying habits. Inventory distortion means that the costs included in ending inventory are typically old (lower) costs; as a result, ending inventory isn't valued at replacement cost. Physical flow refers to the idea that LIFO does not accurately match the physical flow of goods in most companies. Inventory liquidation refers to the strange results that occur when a company's sales are greater than its purchases and extremely old, low costs get transfered into cost of goods sold. Poor buying results from the fact that management may ensure purchases are greater than sales in order to ensure old costs are not charged to cost of goods sold.

    Consider a company that has the following purchases over the course of the year. The company also has 200 units in beginning inventory, each valued at $10.50, and 250 units in ending inventory.



    We can calculate the value of ending inventory by looking at the oldest costs first. Under LIFO, if we have 250 units in ending inventory, we assume that 200 of those units are from our beginning inventory, and 50 units are from our first order in January.



    We can calculate cost of goods sold by subtracting our value for ending inventory from our total purchases plus beginning inventory.

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