Which inventory method will result in the lowest reported net income during periods with rising costs?

How Does Inflation and Deflation Affect Profitability of Product Sales?

In an inflationary period is when the value of a currency decreases and, thus, the price of goods rise. Deflation is the exact opposite. As such, these occurrences have an effect on the financial statements and how inventory is reported. 

The effect of each method is discuss below. 

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How is the Specific Identification Method Affected by Inflation? 

Specific notification will always yield the results that are dependent on which units are sold. As such, inflation and deflation are not going to change specific identification.

How is FIFO Inventory Method Affected by Inflation? 

In an inflationary period, FIFO (or First-in, First Out) will result in higher immediate profit margins. The cost of older goods will be lower than the cost of newer goods. So, selling off older goods first will result in a higher profit margin. The exact opposite is true in a deflationary period. 

How is LIFO Inventory Method Affected by Inflation? 

In an inflationary period, LIFO (or Last-in, First Out) will result in a lower immediate profit margin. The cost of new goods is higher than that of older goods. So, selling off new goods first yields a lower margin that the LIFO or specific identification method. The exact opposite is the case in a deflationary period. 

How is the Weighted Average Inventory Method Affected by Inflation? 

During an inflationary period, the weighted average method will result in a profit yield somewhere in between LIFO and FIFO. 

Related Topics

• Do It Right the First Time (DRIFT) Definition
• What is Merchandise Inventory (Retail Inventory Method)? – Financial Accounting
• What are Inventory Costs (Carrying Costs)? – Financial Accounting
  
  • Obsolete Inventory Definition
  • Shrinkage (Inventory) Definition
• Specific Identification Method of Accounting for Inventory – Financial Accounting
• First-in, First-Out Method (FIFO) – Financial Accounting
• Last-In, First-Out Method (LIFO) – Financial Accounting
• Weighted-Average Method of Accounting for Inventory – Financial Accounting
• Financial Statement Effects (Inflationary vs Deflationary Periods) – Financial Accounting
• Intermittent Purchase and Sell
• Choosing an Accounting Method – Financial Accounting
• Effect of Each Accounting Method on Taxes – Financial Accounting
• Lower of Cost or Market Method of Accounting for Inventory – Financial Accounting

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.

Which inventory costing method produces the lowest net income?

Which inventory method is best for rising prices?

Which cost flow method gives the lowest net income when inventory prices are increasing?

Which inventory method produces the lowest income tax during a period of inflation?