Accounting: The Language of Business (Part 53)

“Accounting for the most part, remains a legalistic and traditional practice, almost immune to self-criticism by scientific methods.” —Kenneth E. Boulding

Inventories (Part E)

by

Charles Lamson

Comparing Inventory Costing Methods

As was illustrated in part 52, a different cost flow is assumed for each of the three alternative methods of costing inventories. You should note that if the cost of units had remained stable, all three methods would have yielded the same results. Since prices do change, however, the three methods will normally use different amounts for (1) the cost of the merchandise sold for the period, (2) the gross profit (and net income) for the period, and (3) the ending inventory. Using the preceding examples (from part 52) for the periodic inventory system and assuming the net sales were $15,000, the following partial income statements indicate the effects of each method when prices are rising:

As shown above, the fifo method yielded the lowest amount for the cost of merchandise sold and the highest amount for gross profit (and net income). It also yielded the highest amount for the ending inventory. On the other hand, the lifo method yielded the highest amount for the cost of merchandise sold, the lowest amount for gross profit (and net income), and the lowest amount for ending inventory. The average cost method yielded results that were between those of fifo and lifo.

Use of the First-In, First-Out Method

When the fifo method is used during a period of inflation or rising prices, the earlier unit costs are lower then the more recent unit costs, as shown in the preceding fifo example. Thus, fifo will show a larger gross profit. However, the inventory must be replaced at prices higher than indicated by the cost of merchandise sold. In fact, the balance sheet will report the ending merchandise inventory at an amount that is about the same as its current replacement cost. When the rate of inflation reaches double digits, as it did during the 1970s, the larger gross profits that result from the fifo method are often called inventory profits or illusory profits. You should note that in a period of deflation or declining prices, the effect is just the opposite.

Use of the Last-In, First-Out Method

When the lifo method is used during a period of inflation or rising prices, the results are opposite those of the other two methods. As shown in the preceding example, the lifo method will yield a higher amount of cost of merchandise sold, a lower amount of gross profit, and a lower amount of inventory at the end of the period than the other two methods. The reason for these effects is that the cost of the most recently acquired two units is about the same as the cost of their replacements. In a period of inflation, the more recent unit costs are higher than the earlier unit costs. Thus, it can be argued that the lifo method more nearly matches current costs with current revenues.

During periods of rising prices, using lifo offers an income tax savings. The income tax savings results because lifo reports the lowest amount of net income of the three methods. During the double-digit inflationary period of the 1970s, many businesses changed from fifo to lifo for the tax savings. However, the ending inventory on the balance sheet may be quite different from its current replacement cost. In such cases, the financial statements normally include a note that states the estimated difference between the lifo inventory and the inventory if fifo had been used. Again, you should note that in a period of deflation or falling price levels, the effects are just the opposite.

Use of the Average Cost Method

As you might have already reasoned, the average cost method of inventory costing is, in a sense, a compromise between fifo and lifo. The effect of price trends is averaged in determining the cost of merchandise sold and the ending inventory. For a series of purchases, the average cost will be the same, regardless of the direction of price trends. For example, a complete reversal of the sequence of unit costs presented in the preceding illustration would not affect the reported cost of merchandise sold, gross profit, or ending inventory. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 365-367*

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