LIFO (which is the acronym for Last In, First Out) is a cost flow assumption in which the most recent costs of inventory items are the first costs to be removed from inventory and reported as the
cost of goods sold. As a result, the older costs remain in inventory. FIFO (which is the acronym for First In, First Out) is a cost flow assumption in which the oldest costs of inventory items are the first costs to be removed from inventory and reported as the cost of goods sold. As a result, the most recent costs remain in
inventory. Net sales - Cost of goods sold = gross profit? If there were no changes in the cost of inventory items (purchased or manufactured), there would be no difference between
the LIFO and FIFO cost flows. Since costs have historically increased, the latest or most recent costs are higher than the older costs. When the recent higher costs are removed from inventory and reported as the cost of goods sold on the income statement, the resulting gross profit will be lower. If the corporation ends up with lower taxable income, it likely means lower income tax expense. Example Comparing LIFO and FIFOABC Store purchases a product and then sells them to its retail customers. ABC began on January 2 and purchased 1 unit of product in each of the following months at these costs: $10 in January, $12 in April, $13 in October. Therefore, ABC's cost of goods available amounted to $35. Next, assume that 2 units were sold and 1 is in inventory on December 31. Also assume that the retail price remained constant at $16 each. Using the LIFO cost flow assumption, the cost of the 2 units sold will be $25 ($13 + $12) Gross profit using LIFO: Sales of $32 - COGS $25 = $7 Note that the LIFO gross profit is $3 less than the FIFO gross profit. Inventory includes raw materials, partially finished goods and finished goods. A retail business may have finished goods awaiting shipment, while a manufacturing business may have raw materials and partially completed products that require further processing before sale. The choice of an inventory valuation method affects the calculation for cost of goods, which affects gross profit and net income. Basics
FIFO
LIFO
Weighted Average
Specific Identification
Does LIFO produce higher net income?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.
Does FIFO result in higher or lower net income?FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS.
Does FIFO or LIFO have higher gross profit?On the contrary, under LIFO, the cost of inventory would be the most recent one, therefore would be the highest. This leads to FIFO showing a higher profit in the income statement as compared to a company following LIFO.
What inventory method gives the highest net income?LIFO gives the most realistic net income value because it matches the most current costs to the most current revenues. Since costs normally rise over time, LIFOs can result in the lowest net income and taxes.
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