The Gross Profit Percentage Using LIFO

The newest inventory is the first to be sold when using the LIFO method.

Companies have three methods they can use to calculate the cost of goods sold: the "first in, first out" (FIFO) method, the "last in, first out" (LIFO) method and the "weighted-average" method. If your company uses LIFO to calculate its cost of good sold, it can avoid paying high taxes, but it may have to answer to investors regarding its low fiscal income.

LIFO Definition

Accountants use the LIFO method for assigning costs to inventory when they want to use the last price paid per batch of inventory purchased. For example, if a company stockpiles inventory and pays $1,000 in January for 500 units of inventory, $1,200 in May for 500 units and $1,400 in October for 500 units, the company would base its cost of goods sold on the $1,400 batch until it was depleted. So, if the company sells 700 units of product, 500 units would cost $1,400 (the cost of the last inventory added) and the remaining 200 units would cost $480 (based on the $1,200 paid for the 500 units in May).

Gross Profit Percentage Calculation

To calculate the gross profit percentage for your company, you need to first calculate the gross profit. Gross profit is the total revenue of your company minus operating costs and costs of goods sold. For example, a company with $100,000 in revenue, $20,000 in operating costs and $30,000 in cost of goods sold has a gross profit of $50,000. The gross profit of $50,000 divided by the revenue of $100,000 equals a gross profit percentage of 50 percent. The cost of goods sold depends on accurate LIFO pricing; each inventory batch has its own price that makes up the cost of goods sold.

Advantages

Companies that use the LIFO method of accounting for inventory typically do so to decrease their income before taxes at the end of the fiscal year. The cost of goods sold under the LIFO method is usually higher because of increasing inventory costs through the year. A lower income means the tax burden for a company is lower for the year, freeing up capital for other purposes.

Disadvantages

Companies that use LIFO are required by federal law to use the method for both income tax returns and financial reporting. Though the tax burden for the company is lower, the reported income for the year is also lower. A lower reported income may affect the company's stock price and its ability to secure financing for operations. Profit is turned into stockholders' equity at the end of the fiscal year, and lower profit means less equity for shareholders.

References

• Prnciples of Accounting: Inventory
• Understand Accounting: Inventory and Costs of Goods Sold
• Accounting Coach: Inventory and Cost of Goods Sold