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 2011 using the LIFO cost flow assumption. It ended the year 2011 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 2012 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 2011 remaining in inventory (10 X $20 = $200) and an additional layer being added in 2012. The 2012 LIFO layer will be the 2012 cost of 5 units (5 X $21 = $105). The LIFO inventory cost at the end of 2012 will be the 2011 LIFO base layer of $200 + the 2012 LIFO layer of $105...for a total LIFO inventory cost of $305.
Next, let's assume that in 2013 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 purchased in 2012 at $21 each. In other words, Jay Corp. had to peel away part of the 2012 layer since that was the most recently added layer. This means the LIFO cost of inventory at the end of 2013 will consist of the 2011 LIFO base layer of 10 units at $20 each + the 2012 LIFO layer now at 3 units at their 2012 cost of $21 each...for a total LIFO inventory cost at the end of 2013 of $263 ($200 + $63).
If Jay Corp. increases its inventory during 2014 by 4 units at a cost of $22 each , a new 2014 LIFO layer of 4 units would be added. The LIFO cost for the inventory at the end of 2014 would be the following: the 2011 base layer (10 units at the 2011 cost of $20 each) + the 2012 LIFO layer (3 units at the 2012 cost of $21 each) + the 2014 LIFO layer (4 units at the 2014 cost of $22 each).