2. which inventory method results in the highest net income during periods of falling prices?

By Chron Contributor Updated November 19, 2020

Your company has three inventory costing methods from which to choose. The choice is important because it influences your cost of goods sold, net income and income tax payable. Whichever method you choose, accounting rules call for you to stick with it; the Internal Revenue Service might not allow you to flip-flop your accounting method just to take advantage of the latest price trend.

Last-in, first-out, or LIFO, uses the most recent costs first. When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income. If you sell one-of-a-kind items like custom jewelry, you might prefer the specific identification method. You record the cost of each item, so the cost of goods sold doesn’t require as much fancy math.

When you use the periodic, or book, inventory system, you value your inventory at specific intervals and lump together the results. For example, suppose you purchase 10 items at $100 each on the first of the month. On the 14th, you sell six items and on the 16th buy another 10 for $120 each. You sell eight items on the 19th and buy another 10 on the 23rd for $130 each. On the last day of the month, you sell nine items. Under periodic inventory LIFO, your cost of goods sold is the sum of 10 items times $130, 10 items times $120 and three items times $100. This adds up to $2,800, and you value your remaining inventory at $700.

In the perpetual inventory system, you figure the cost at the time of each sale instead of at specific intervals. Your cost of goods sold on the 14th is six items times $100, or $600. The sale on the 19th costs $120 times eight units, or $960. The last sale costs $130 times nine items, or $1,170. Notice that each sale uses the latest item cost, which simplifies the math. The total cost is $2,730, or $70 less than the cost under the periodic inventory method. Your remaining inventory tallies in at $770. Your taxable income is $70 less using the periodic inventory system. If you are in the 25 percent bracket, this translates into a tax savings of $17.50.

Since prices always seem to increase over time, LIFO is a good bet for consistently maximizing your cost of goods sold. The example deals with a retail situation but also applies to product manufacturers. However, if you manufacture products using raw materials that fluctuate in price, such as petroleum, you may not always benefit from the LIFO method. The IRS lets you initially choose your inventory accounting method but wants you to use it consistently year to year. If you choose LIFO, you must file IRS Form 970 in the first year you use this method. If you want to change methods, you might need to ask for IRS approval by filing Form 3115.

A company normally wants to minimize income in order to pay the least tax. However, certain circumstances motivate a company to want high income. For instance, management may believe the company’s stock is priced too low or feels under pressure to hit specific income targets. Management has an arsenal of techniques to boost reported income, including the choice of inventory methods.

Estimated Ending Inventory

1. To achieve the highest income, you need to minimize the cost of goods sold for the period. The income statement calculates gross income as sales minus COGS. All other things being equal, the lower the COGS, the higher the income. The COGS determines ending inventory value according this equation: cost of goods available for sale minus COGS equals cost of ending inventory. You figure cost of goods available for sale by adding inventory purchases for the period to beginning inventory. You can influence COGS and thus income by your choice of inventory valuation methods.

First In, First Out

1. If you want to minimize COGS, you must sell your lowest-cost inventory first. Generally, wholesale prices rise over time, so the oldest inventory items are normally the least expensive. You’ll therefore minimize COGS by using the first in, first out method during periods of rising prices. Under FIFO, you assign inventory costs in purchase date sequence. Because FIFO has you subtract the cost of your oldest -- and therefore least expensive -- inventory from sales, your gross income is higher. The actual physical inventory that you sell need not be the oldest -- FIFO refers to costing flow, not necessarily to picking order.

Other Costing Flows

1. If you operate during a period of falling wholesale prices, you minimize COGS by using the latest inventory costs first. This is the last in, first out method, in which you assign costs in reverse purchase date order. Your other choices are the average cost method -- you calculate the weighted average inventory cost for the period -- and the specific identification method, in which you track the cost of each item separately. Assuming no beginning inventory, if wholesale prices are perfectly flat for the period, all four methods produce identical results. Otherwise, the average method and specific identification method create a COGS intermediate between those created by LIFO and FIFO. By the way, you cannot switch costing flows back and forth each year -- the Internal Revenue Service won't allow it. Also, you need to file IRS Form 970 when you first start using LIFO.

Non-Flow Methods

1. You can estimate ending inventory and COGS without adopting a flow assumption via two other methods. In the retail inventory method, you estimate the ratio of costs to retail prices using historical data. You compute COGS by applying this ratio to period sales. Under the gross profit method, you multiply sales by the 1 minus the expected gross margin percentage -- markup divided by sales -- to compute COGS. In both methods, lower ratios lead to lower COGS. To the extent that a company can manage the ratio it uses to calculate COGS, it can increase income by using the lowest possible value for the ratio. Depending on how aggressively you set your ratio, you might achieve a lower COGS and higher income through a non-flow method than with FIFO or LIFO. Bear in mind that the IRS might frown on a ratio you cannot justify.

Last in, first out (LIFO) is a method used to account for inventory that records the most recently produced items as sold first. Under LIFO, the cost of the most recent products purchased (or produced) are the first to be expensed as cost of goods sold (COGS), which means the lower cost of older products will be reported as inventory.

Two alternative methods of inventory-costing include first in, first out (FIFO), where the oldest inventory items are recorded as sold first, and the average cost method, which takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine COGS and ending inventory.

• Last in, first out (LIFO) is a method used to account for inventory.
• Under LIFO, the costs of the most recent products purchased (or produced) are the first to be expensed.
• LIFO is used only in the United States and governed by the generally accepted accounting principles (GAAP).
• Other methods to account for inventory include first in, first out (FIFO) and the average cost method.
• Using LIFO typically lowers net income but is tax advantageous when prices are rising.

Last in, first out (LIFO) is only used in the United States where all three inventory-costing methods can be used under generally accepted accounting principles (GAAP). The International Financial Reporting Standards (IFRS) forbids the use of the LIFO method.

Companies that use LIFO inventory valuations are typically those with relatively large inventories, such as retailers or auto dealerships, that can take advantage of lower taxes (when prices are rising) and higher cash flows.

Many U.S. companies prefer to use FIFO though, because if a firm uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to shareholders, which lowers net income and, ultimately, earnings per share.

When there is zero inflation, all three inventory-costing methods produce the same result. But if inflation is high, the choice of accounting method can dramatically affect valuation ratios. FIFO, LIFO, and average cost have a different impact:

• FIFO provides a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value COGS. Increasing net income sounds good, but it can increase the taxes that a company must pay.
• LIFO is not a good indicator of ending inventory value because it may understate the value of inventory. LIFO results in lower net income (and taxes) because COGS is higher. However, there are fewer inventory write-downs under LIFO during inflation.
• Average cost produces results that fall somewhere between FIFO and LIFO.

If prices are decreasing, then the complete opposite of the above is true.

Assume company A has 10 widgets. The first five widgets cost $100 each and arrived two days ago. The last five widgets cost $200 each and arrived one day ago. Based on the LIFO method of inventory management, the last widgets in are the first ones to be sold. Seven widgets are sold, but how much can the accountant record as a cost?

Each widget has the same sales price, so revenue is the same, but the cost of the widgets is based on the inventory method selected. Based on the LIFO method, the last inventory in is the first inventory sold. This means the widgets that cost $200 sold first. The company then sold two more of the $100 widgets. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100. In contrast, using FIFO, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200.

This is why in periods of rising prices, LIFO creates higher costs and lowers net income, which also reduces taxable income. Likewise, in periods of falling prices, LIFO creates lower costs and increases net income, which also increases taxable income.