What are LIFO layers?

LIFO is the acronym for Last-In, First-Out. In the context of inventory, it means that the cost of the most recently purchased units will be the first costs to be matched with the recent sales on the income statement. (The oldest costs will remain in inventory.) When the end of the year quantity of inventory increases, the cost of the recently added units becomes a new layer—another LIFO layer. If the end of the year inventory quantity decreases, LIFO layers are “peeled away” starting with the latest (most recent) layer first. We will illustrate this with the following example.

Jay Corp. begins operations in 2005 using the LIFO cost flow assumption. It ended the year 2005 with 10 units in inventory at a cost of $20 each. Therefore its LIFO inventory consists of one layer (its base layer) having a cost of $200. During 2006 Jay Corp. purchased 100 units at $21 each and sold 95 units. Under the LIFO cost flow assumption, it is assumed that the 95 units sold had the most recent cost of $21 (even if the most recently purchased units were not physically shipped out to customers). The LIFO cost flow assumption results in the cost of the 10 units from 2005 remaining in inventory (10 X $20 = $200) and an additional layer being added in 2006. The 2006 LIFO layer will be the 2006 cost of 5 units (5 X $21 = $105). The LIFO inventory cost at the end of 2006 will be the 2005 LIFO base layer of $200 + the 2006 LIFO layer of $105…for a total LIFO inventory cost of $305.

Next, let’s assume that in 2007 Jay Corp. purchases 100 units at $22 and sells 102 units. The LIFO cost flow assumption is that the 102 units sold would consist of the cost of the recently purchased 100 units at $22 plus the cost of 2 units puchased in 2006 at $21 each. In other words, Jay Corp. had to peel away part of the 2006 layer since that was the most recently added layer. This means the LIFO cost of inventory at the end of 2007 will consist of the 2005 LIFO base layer of 10 units at $20 each + the 2006 LIFO layer now at 3 units at their 2006 cost of $21 each…for a total LIFO inventory cost at the end of 2007 of $263 ($200 + $63).

If Jay Corp. increases its inventory during 2008 by 4 units at a cost of $22 each , a new 2008 LIFO layer of 4 units would be added. The LIFO cost for the inventory at the end of 2008 would be: The 2005 base layer (10 units at the 2005 cost of $20 each) + the 2006 LIFO layer (3 units at the 2006 cost of $21 each) + the 2008 LIFO layer (4 units at the 2008 cost of $22 each).

Learn more about Inventory & Cost of Goods Sold.