LIFO Liquidation

LIFO liquidation occurs when a company that uses the last in, first out (LIFO) inventory costing method liquidates its older LIFO inventory. A LIFO liquidation occurs when current sales exceed purchases, resulting in the liquidation of any inventory not sold in a previous period. 

The LIFO method is a financial practice in which a company sells the most recent inventory purchased first.  LIFO matches the most recent costs against current revenues. Some companies use the LIFO method during periods of inflation when the cost to purchase inventory increases over time.  The LIFO method provides tax benefits as the higher costs associated with new inventories seemingly offset profits, resulting in a lower tax burden.

ABC Company uses the LIFO method of inventory accounting for its domestic stores. It purchased one million units of a product annually for three years. The per unit cost is $10 in year one, $12 in year two, and $14 in year three, and ABC sells each unit for $50.  It sold 500,000 units of the product in each of the first three years, leaving a total of 1.5 million units on hand. Assuming that demand will remain constant, it only purchases 500,000 units in year four at $15 per unit. 

Despite their forecast, consumer demand for the product increased; ABC sold 1,000,000 units in year four.  Under the LIFO method, 500,000 units from year four are liquidated, resulting in revenues of  $25,000,000, COGS of $7,500,000, and gross profits of $17,500,000; and 500,000 units from year three are liquidated resulting in revenues of $25,000,000, COGS of $7,000,000, and gross profits of $18,000,000.