Understanding LIFO Liquidation: Definition, Mechanism, and Real-World Example

What Is LIFO Liquidation?

LIFO liquidation happens when a business using the last-in, first-out (LIFO) inventory valuation method sells off its older inventory layers. This situation arises when the volume of sales surpasses new inventory purchases, triggering the depletion of previously acquired stock.

Essential Insights

• LIFO liquidation involves selling older inventory that was acquired before the most recent stock.
• This process is part of the LIFO inventory accounting approach, which prioritizes the newest inventory costs against current sales.
• LIFO aligns recent purchase costs with current revenue, aiding in accurate profit measurement.
• Many businesses adopt LIFO during inflationary periods to manage rising inventory costs effectively.

How Does LIFO Liquidation Operate?

The LIFO method prioritizes selling the latest inventory bought, matching the newest costs with current income. It is especially valuable during inflation, as it increases cost of goods sold, thereby reducing taxable income. When sales exceed purchases, older inventory layers are liquidated, which can temporarily increase reported profits and affect tax liabilities.

Illustration of LIFO Liquidation

Consider ABC Company, which applies the LIFO accounting method in its domestic outlets. Over three years, it consistently buys 1 million units annually, with unit costs rising from $10 in year one to $12 in year two, and $14 in year three. Each unit sells for $50. The company sells 500,000 units each year during these three years, resulting in 1.5 million units remaining in inventory. In year four, anticipating steady demand, ABC purchases only 500,000 units at $15 each.

Contrary to expectations, demand surges in year four, and ABC sells 1 million units. Using LIFO, 500,000 units from the latest purchase are sold first, generating $25 million in revenue, $7.5 million in cost of goods sold, and $17.5 million in gross profit. Next, 500,000 units from the previous year's inventory are sold, producing another $25 million in revenue, $7 million in cost of goods sold, and $18 million in gross profit.

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