What is 'LIFO Liquidation'
LIFO liquidation happens when a company uses the last in first out (LIFO) method of inventory costing, and then liquidates its older LIFO inventory. A LIFO liquidation occurs if current sales are higher than its purchase of inventory, which, as a result, forces the company to liquidate any inventory not sold in a previous period. This liquidation causes a distortion in a company's net operating income, because the lower-cost inventory is recognized on its income statement.
BREAKING DOWN 'LIFO Liquidation'The LIFO method of inventory accounting is a financial practice where the most recent inventory purchased is sold first. Essentially, when a company sells a unit of its good or service, the revenue is matched with the newest inventory. The LIFO method is used by companies during periods of rising prices, or periods of rising inflation, when the cost to purchase inventory increases over time. This is used because the higher priced inventory is matched to current revenue, increasing costs of goods sold (COGS) and decreasing earnings before tax (EBT), which lowers a company's tax burden.
However, if a company faces a LIFO liquidation event when sales outpace current inventory, the business is forced to use older and older inventory at increasingly lower prices. This results in a higher tax liability, which is the opposite of the desired effect. The tax advantage of LIFO accounting , then, quickly turns into a disadvantage due to the fact that the older, lower costs of inventory are matched with current revenues.
An Example of LIFO Liquidation
Walmart uses the LIFO method of inventory accounting for its domestic stores. Over a four year period, for example, it might purchase one million units of a specific product in each of the first three years. However, due to rising prices, the per unit cost of its inventory is $10 in year one, $12 in year two, $14 in year three. The product is sold for a price of $50 a piece over the three year period. However, Walmart only sells 500,000 units of the product in each of the first three years, leaving 1.5 million units on hand. Since it assumes that demand won't increase, it only purchases 500,000 units of inventory in year four, for a per-unit cost of $15. If it continues to sell the product for $50, this strategy is beneficial in that it reduces its tax burden.
However, demand for the product unexpectedly goes up and Walmart immediately sells all 500,000 units of the product in year four for total sales of $25,000,000, total COGS of $7,500,000 and a gross profit of $17,500,000. Consumer demand continues to increase, and Walmart is forced to liquidate its older inventory, selling an additional 500,000 units from year three, for revenues of $25,000,000 but total COGS of $7,000,000, meaning that its gross profit for the inventory sold from year three is $18,000,000. The combined gross profit is $500,000 higher than if the company had purchased all of its inventory for a cost of $15, increasing its tax burden.