LIFO LiquidationDefined with Formula & More

Written By:
Lisa Borga

What is LIFO Liquidation?

A LIFO liquidation refers to when a company using the last-in-first-out (LIFO) inventory valuation method sells or liquidates its older inventory suddenly.

This occurs when such a company’s sales exceed its purchases of inventory, resulting in the sale of leftover inventory from previous periods.

Many companies avoid such a liquidation due to the sudden and significant impact this can have on its profit and taxes.

Due to inflation, older inventory will typically be purchased and carried at a lower price.

This means that when older inventory is sold, it will reduce the cost of goods sold over newer inventory which will result in higher gross profits and, in turn, more income tax.

Understanding LIFO Liquidation

Under the LIFO valuation method, the most recently purchased inventory will be sold first.

This means that the costs of the most recent purchases of inventory will be recorded against current revenue.

This is in direct contrast to the first-in-first-out (FIFO) method in which the oldest inventory is sold.

Though a less common choice, the LIFO method can have some benefits, such as during times in which inflation is high, and the cost of purchasing inventory will increase rapidly over time.

Because the higher costs of purchasing its newest inventory will be matched with a company’s current revenue during such a period, it will appear to offset profits to a greater extent reducing its tax burden.

However, when sales exceed current purchases due to unexpected demand, inability to purchase new inventory, a desire to clear old inventory, an attempt to raise reported profits, or another reason, these older, lower costs will be matched with current revenue resulting in a LIFO liquidation.

Due to matching the lower cost of goods sold associated with older inventory, reported profits will be higher, but this will result in a greater tax burden.

Example of LIFO Liquidation

XYZ Retailers uses the LIFO inventory valuation method. In the three years from 2017 to 2019, it purchased 750,000 units of product A every year to sell at a price of $20 each.

XYZ sold 500,000 in each of these years.

As a result, in 2020, XYZ decided that demand would remain at this level and chose to order only 500,000 units in 2020.

The price for product A rose yearly, going from $5 in 2017, $7 in 2018, $9 in 2019, and $11 in 2020.

The yearly spending looked like this:

However, demand suddenly rose in 2022, and XYZ sold 1,000,000 units of product A in 2020.

Using LIFO, this means that the 500,000 units purchased in 2020 would be accounted for first with a cost of goods sold of $5,500,000, revenue of $10,000,000, and a gross profit of $4,500,000.

Following this, the 250,000 units from 2019 would be liquidated, followed by 250,000 units from 2018.

This would result in the following cost of goods sold and gross profit for each year’s inventory.

Key Takeaways

• LIFO liquidation occurs when a business using LIFO inventory costing sells its older inventory first.
• LIFO liquidation may be caused by several issues, including the inability to purchase new inventory, cash flow issues, or unexpectedly high demand.
• Some companies may choose to execute LIFO liquidation in order to boost reported profits or to get rid of inventory in order to clear storage space for other goods.