Advantages and disadvantages of LIFO method in cost accounting

Last-in-First out method (LIFO) – It is a method of pricing the issues of materials. This method is based on the assumption that the items of the last batch (lot) purchased are the first to be issued. Therefore, under this method the prices of the last batch (lot) is used for pricing the issues, until it is exhausted, and so on. If however, the quantity of issue is more than the quantity of the latest lot than earlier (lot) and its price will also be taken into consideration. During inflationary period or period of rising prices, the use of LIFO would help to ensure that the cost of production determined on the above basis is approximately the current one. This method is also useful specially when there is a feeling that due to the use of FIFO or average methods, the profits shown and tax paid are too high.

The advantages and disadvantages of LIFO method are as follows :

Advantages :

1. The cost of materials issued will be either nearer to and or will reflect the current market price. Thus, the cost of goods produced will be related to the trend of the market price of materials. Such a trend in price of materials enables the matching of cost of production with current sales revenues.

2. The use of the method during the period of rising prices does not reflect undue high profit in the income statement as it was under the first-in-first-out or average method. In fact, the profit shown here is relatively lower because the cost of production takes into account the rising trend of material prices.

3. In the case of falling prices profit tends to rise due to lower material cost, yet the finished products appear to be more competitive and are at market price.

4. Over a period, the use of LIFO helps to iron out the fluctuations in profits.

5. In the period of inflation LIFO will tend to show the correct profit and thus avoid paying undue taxes to some extent.

Disadvantages :

1. Calculation under LIFO system becomes complicated and cumbersome when frequent purchases are made at highly fluctuating rates.

2. Costs of different similar batches of production carried on at the same time may differ a great deal.

3. In time of falling prices, there will be need for writing off stock value considerably to stick to the principle of stock valuation, i.e., the cost or the market price whichever is
lower.

4. This method of valuation of material is not acceptable to the income tax authorities.