# Contrasting Cost Flow Assumptions

This article analyzes FIFO, average cost, and LIFO cost flow assumptions on Cerf Company ending inventory, cost of goods sold, and gross margin.

FIFO produced the highest gross margin, ending inventory, and lowest cost of goods sold, as demonstrated in the table below.

LIFO had the lowest gross margin, ending inventory, and highest cost of goods sold.

All three accounts had an average cost between these two extremes. This is because inventory acquisition prices climb from \$4.10 to \$4.70 over the year.

We designed this example to show escalating pricing. Because prices rise more than fall in today’s economy.

Some industries, like electronics, have seen price drops.

LIFO and FIFO would have the opposite income statement and balance sheet effects as rising prices.

LIFO would have the maximum gross margin and inventory cost.

## FIFO and rising prices

FIFO has the largest gross margin and ending inventory during price increases.

The cost of products sold has the highest gross margin because it is assigned first and has the lowest costs.

Thus, cost of goods sold is the lowest and gross margin the greatest among the three inventory costing techniques.

Ending inventory has the highest cost under FIFO because it receives the newest and highest costs.

Given the gross margin-ending inventories relationship, these findings are expected.

FIFO is approved by many accountants since ending inventories are recorded at costs close to their acquisition or replacement cost.

## Thus, the firm’s balance sheet values inventory realistically.

However, other accountants criticize FIFO for matching the earliest expense to sales and maximizing gross profit.

Some accountants believe these earnings are inflated because a running corporation must replace its inventory at current acquisition prices or replacement costs to survive.

Inventory profits are inflated earnings.

Example

Suppose a corporation makes these transactions to demonstrate inventory profits:

Purchases one \$60 inventory item on January 2.

Buys another \$85 inventory item on December 15.

31 December: Sells one unit for \$100—inventory replacement cost is \$85

The firm’s FIFO gross margin is \$40 (\$100 — \$60). If the company survives, it won’t have \$40 for running expenses.

Because it must replace inventory for at least \$85.

## Thus, the firm has just \$15 (\$100 – \$85) to cover operating expenses.

Inventory profit is \$25, the difference between \$85 replacement cost and \$60 historical cost.

The inventory profit is a holding gain from the inventory’s acquisition price increase between the firm’s purchase and sale.

This holding gain must be used to acquire inventory at higher prices, so it cannot pay operational expenditures.

## Increasing Prices and LIFO

LIFO has the lowest gross margin and ending inventory in a rising-price environment.

When the latest and highest costs are added to cost of goods sold, gross margin drops.

Thus, cost of goods sold is the greatest and gross margin the lowest of the three inventory costing techniques.

LIFO records ending inventory at the lowest cost of the three techniques since it uses the earliest and lowest pricing.

The first LIFO layers, if unsold, would cost 20 years old pricing if a corporation moved to LIFO 20 years ago.

LIFO has the opposite effect on the balance sheet and income statement as FIFO.

Therefore, LIFO is criticized because the balance sheet inventory cost is sometimes excessively low.

Thus, current assets, current ratio, and working capital are overstated. As shown in the 2019 Safeway annual report, the repercussions may be severe:

2019 consolidated working capital rose to \$303 million from \$231 million and \$218 million in 2018 and 2017. The current ratio rose from 1.15 and 1.16 to 1.19.

If the company valued its inventories using FIFO, its current ratio would have been 1.40, 1.35, and 1.36, and its working capital would have been \$621 million, \$520 million, and \$508 million at 2019, 2018, and 2017 year-ends.

## However, many accountants believe LIFO gives a more accurate income figure. It reduces inventory profit significantly.

The firm’s LIFO gross margin is \$15, as shown in this page’s basic example. Matching the 15 December 2019 purchase with the \$100 sale.

Between the last buy on 15 December and its sale on 31 December, the inventory acquisition price did not change. This eliminates all inventory profits.

LIFO will lower inventory earnings, not eliminate them. Eliminating inventory profits from the income statement might be extreme.

The Safeway annual report found that LIFO inventory lowered gross profitability by \$29.3 million in 2019. This is significant given Safeway’s 2020 net income of \$185.0 million.

In conclusion, rising prices affect the balance sheet and income statement differently for FIFO and LIFO.

While LIFO delivers a fair income statement, it hurts the balance sheet. While FIFO delivers a fair balance sheet, it sacrifices the revenue statement.

In dropping prices, the opposite is true. In either scenario, the average cost will compare FIFO and LIFO.