Comparison Between Different Cost Flow Assumptions
Presented below is a comparison of the effect of the FIFO, average cost, and LIFO cost flow assumptions on ending inventory, cost of goods sold, and gross margin for the Cerf Company (we have not included specific identification in this comparison because of its limited use). The highest gross margin and ending inventory and lowest cost of goods sold result when FIFO is used; the lowest gross margin and ending inventory and highest cost of goods sold result when LIFO is used. The average cost falls between these two extremes for all three accounts.
This is because the acquisition price of the inventory consistently rises during the year, from $4.10 to $4.70. We deliberately constructed this example to reflect rising prices because, in today’s economy, rising prices are more common than are falling prices. However, in some sectors of the economy, such as electronics, prices have been falling. In this case, the income statement and balance sheet effects of LIFO and FIFO would be the opposite of the rising-price situation. That is, LIFO would Produce the highest gross margin and the highest ending inventory cost.
Note: The figures are taken from the example illustrated in the article “Applications of different cos flow assumptions“.
Rising Prices and FIFO
In a period of rising prices, FIFO produces the highest gross margin and the highest ending inventory. The high gross margin is produced because the earliest and thus the lowest costs are allocated to cost of goods sold. Thus, cost of goods sold is the lowest of the three inventory costing methods, and gross margin is correspondingly the highest of the three methods.
Ending inventory reflects the highest cost under FIFO because the latest and highest costs are allocated to ending inventory. These results are logical, given the relationship between ending inventories and gross marøn. On one hand, many accountants approve of using FIFO because ending inventories are recorded at costs that approximate their current acquisition or replacement cost. Thus, inventories are realistically valued on the firm’s balance sheet.
On the other hand, accountants criticize FIFO because it matches the earliest cost against sales and results in the highest gross margin. Some accountants argue that these profits are overstated because in order to stay in business, a going concern must replace its inventory at current acquisition prices or replacement costs. These overstated profits are often referred to as inventory profits.
To illustrate further the concept of inventory profits, assume that a firm enters into the following transactions:
- January 2: Purchases one unit of inventory at $60.
- December 15: Purchases a second unit of inventory at $85.
- December 31: Sells one unit at $100. Current replacement cost of inventory, $85.
On a FIFO basis, the firm reports a gross margin of $40 ($100 — $60). However, if it is to stay in business, the firm will not have $40 available to cover operating
expenses. This is because it must replace the inventory at a cost of at least $85. Thus, in reality, the firm has only $15 ($100 — $85) available to cover its operating expenses. The $25 difference between the $85 replacement cost and the $60 historical cost is the inventory profit and is considered a holding gain that is caused by the increase in the acquisition price of the inventory between the time that the firm purchased and then sold the item. This holding gain is not available to cover operating costs because it must be used to repurchase inventory at new, higher prices.
Rising Prices and LIFO
In a period of rising prices, LIFO results in the lowest gross margin and the lowest ending inventory. The low gross margin results when the latest and highest costs are allocated to cost of goods sold. Thus, cost of goods sold is the highest of the three inventory costing methods, and gross margin is the lowest of the three methods. Too, under LIFO, the ending inventory is recorded at the lowest cost of the three methods because the earliest and lowest prices are allocated to it. In fact, if a company had switched to LIFO 20 years ago, the original LIFO layers, if unsold, would be costed at 20-year-old prices.
LIFO has the opposite effect of FIFO on the balance sheet and income statement. Consequently, LIFO is criticized because the inventory cost on the balance sheet is often unrealistically low. Therefore, working capital, the current ratio, and current assets tend to be understated. This possible effect can be drastic, as illustrated by the following excerpt from the 2019 Safeway annual report:
Consolidated working capital increased to $303 million in 2019 from $231 million and $218 million in 2018 and 2017, respectively. The current ratio increased to 1.19 from 1.15 and 1.16 in those years. Had the company valued its inventories using the FIFO method, its current ratio would have been 1.40, 1.35 and 1.36, and working capital would have been $621 million, $520 million and $508 million at year-ends 2019, 2018 and 2017, respectively.
Many accountants argue, however, that LIFO provides a more realistic income figure because it eliminates a substantial portion of inventory profit. If you refer back to the simple example on this page, you will see that on a LIFO basis, the firm’s gross margin is $15 because the December 15, 2019 purchase is matched against the $100 sale. In this case, the acquisition price of the inventory did not change between the last purchase on December 15 and its sale on December 31, and so all the inventory profits are eliminated. In reality, LIFO will not eliminate all inventory profits but will substantially reduce them.
The elimination of these inventory profits on the income statement can be drastic. For example, according to the Safeway annual report, the application of the LIFO inventory method reduced gross profits by $29.3 million in 2019. This is a substantial figure, considering that Safeway’s net income for 2020 was $185.0 million.
In summary, in a period of rising prices, FIFO and LIFO have opposite effects on the balance sheet and income statement. LIFO usually provides a realistic income statement at the expense of the balance sheet. Conversely, FIFO provides a realistic balance sheet at the expense of the income statement. In a period of falling prices, the opposite is true. In either case, the average cost will provide figures between those of FIFO and LIFO.
Learning the Financial Impact of Cost Flow Assumptions
Cost flow assumptions are vital because of changing costs and inflation. Learn more about how this impacts your business financially by connecting to a financial advisor in Pittsburgh, PA. For those of you who live outside the area, our financial advisor page will route you to a full list of the areas we currently service.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.