Lesson Objectives:- Comparing the FIFO, LIFO and average cost methods.
- Looking at how each method is recorded on the income statement.
- Comparing the behavior for rising and falling prices.
Now that we've reviewed all of the inventory costing methods, we will be taking a look at how the methods affect the income statement and other accounts. The methods that we will be reviewing are the FIFO, LIFO and average cost methods.
For the purpose of this comparison, we will not be mentioning the specific identification method, as it is more of a straightforward inventory tagging method that is used solely for high value or unique items.
The graphic above depicts the processes that we reviewed in the previous lessons, that we will be comparing in this lesson.
We will bring up a table of transactions, similar to the one that we looked at several times in all of the previous examples. Note that the unit costs and sales prices are increasing over time which reflects that the company is in an inflationary setting.
Inflation is when prices are rising and deflation is when prices are decreasing, which is only the case when using the LIFO method, because the last in products have the highest prices.
Let's compare each inventory costing system based on how it is recorded on the income statement. The operating expenses, sales, beginning inventory, purchases and available inventory will all be the same across all three systems.
What differs between the FIFO, average cost and LIFO system are the final net income figure, gross profit, cost of goods sold and ending inventory. These figures change because they are based on how the inventory costing system is used.
You will notice when looking at these examples that the cost of goods sold figure and the ending inventory figures share an inverse relationship. This means that when the ending inventory is decreasing, the cost of goods sold will increase.
The FIFO method concludes with the most net income, because the cost of goods sold figure is the lowest. As we move through the examples from left to right, the net income figure gradually gets smaller as the cost of goods sold value is higher.
Take note that the net income value is extremely low for the LIFO example which aligns with my statement in the previous lesson that this method can cause net income to be inaccurate.
We can refer back to the example table listed in the beginning of this lesson. That was an example of inflationary prices, because the unit costs and prices were rising. For rising prices, FIFO had the highest amount of inventory, with average in the middle and LIFO with the lowest.
The COGS will be the lowest for FIFO with LIFO being the highest, because with FIFO the cheaper unit costs are expensed first. The net income figure is the highest for FIFO and lowest for LIFO, again because the lower unit costs are expensed first.
If we were to look at a deflationary scenario where the prices were falling, the behavior would be the exact reverse. The FIFO method would have the lowest ending inventory and net income and LIFO would have the lowest COGS. The average cost method always sits right in the middle whether we are looking at an inflationary or deflationary example.