The belief in LIFO costing method is based on the assumption that material issued to manufacturing department should carry the cost of most recent purchase, although the physical flow of material inventory may actually be different. It assumes that the most recent costs are significant to match with recent revenues in the profit / loss determination procedures.
Under LIFO method of inventory valuation the most recent costs are charged to cost of production and oldest costs are left in the inventory. In LIFO costing several different alternatives can be applied and each alternative results in different costs for materials issued and the ending inventory which ultimately results in varying profit figures.
Given below is the order of material movement in and from the storeroom of a firm. Determine the material inventory cost in the material card using LIFO method.
The fundamental difference between the different applications of LIFO method is the time interval between the inventory computations. In the above example of LIFO costing after each receipt and issue a new balance of inventory is calculated along with its value, with the ending inventory consisting of 1000 units having value of $7,800. if a physical instead of perpetual costing procedure is used, whereby the issues are not determined on day to day basis rather are fixed at the end of the period through adding receipts in opening balance and than subtracting the ending inventory from resulting figure, the ending inventory would consist of:
800 units @ $6 (opening inventory)………………………….. $4,800
200 units @ $ 7(oldest purchase)…………………………….. $1,400
1000 units (LIFO inventory at the end of period)………….. $6,200
Even in the circumstances when cost of materials used and ending inventory figures are different, both procedures are appropriate applications of the LIFO method.
Advantages of LIFO Costing
Following advantages are associated with LIFO costing method:[adsense1]
• The rationale of charging most recent costs to the current period production and be compared to the current period revenues results in a systematic and realistic pricing of material consumed.
• Another benefit of LIFO costing is that it minimizes the unrealized gains and losses of inventory and industries facing fast material price fluctuations can stabilize their reported operating profits.
• As in LIFO costing current period inflationary prices of raw material are charged to cost of production and are deducted from revenues, therefore it reduces the profit figure resulting in tax savings. This cash saving advantage enhances the working capital of the firm.
Disadvantages of LIFO Costing
Following disadvantages are associated with LIFO costing method:
• Regulatory bodies often adopt strict measure as a check over LIFO method. In some cases LIFO costing technique is even restricted due to reduction in tax collections to the internal revenue services.
• Record keeping requirements under LIFO are substantially higher than any other method of inventory costing.
• Deterioration or decay of material is maximized due to early use of the latest purchases and latest use of the oldest receipts.
• The Cost Accounting Standards Board does not recognize the use of LIFO method except in some special cases.
Due to accelerated rate of inflation in the last few years the adoption of LIFO costing technique gained some appeal from industries but the decision to adopt LIFO should be taken abruptly without keeping its long term repercussions.