3.9 Inventory Costing Calculations: A Closer Look at the COGS and Ending Inventory Computations
First, it must be recognized that the sales amount is independent of any costing method. For every sale, there is an invoice, and the dollar amount is not at all subject to any choice of accounting inventory costing method.
Under FIFO, the first-in were assumed to be the first-out. So, the cost of goods sold (COGS) figure was the sum of the first four (since four units were sold) costs: $100 + 150 + 200 + 250 = $700. The income statement will show a $700 COGS number as a deduction from sales to arrive at the gross profit of $2,000 – 700 = $1,300. This left $300 in the ending inventory on the balance sheet. Notice that $700 + 300 = $1,000 or the entire inventory cost.
Under LIFO, we must take the last-in, first-out order to compute the sum of the units sold and to arrive at the COGS number. Therefore, we add in reverse chronological order: $300 + 250 + 200 + 150 = $900. The ending inventory will be the first unit acquired, costing $100. Again, the two numbers add up to the sum of the inventory cost: $100 + 900 = $1,000. Gross profits will be lower: $2,000 – 900 = $1,100. Taxes are based on profits. In an inflationary environment, taxes payable will therefore be lower.
Assuming inventory costs rise as often happens when there is inflation, FIFO will always produce a higher gross profit. When corporations expect high inflation (as occurred in the 1970s and in the early 2020s), many will switch to LIFO in order to reduce taxes. Companies pay higher taxes when profits are higher, as might be the case using FIFO, assuming all else equal. To switch to LIFO, the firm must complete IRS Form 970. The corporation cannot go back and forth from one method to the other as the wind blows. You will find the form on the Internet.
The company will prefer LIFO to reduce taxes. It will prefer FIFO to report higher inventory levels and thus show “more” assets to lenders and shareholders. Well, which of the two is preferable in the end? It is permissible for the company to maintain two sets of books, one for filing taxes to the Internal Revenue Service (the IRS) and the other for “reporting.” Moreover, it can use varying methods for different inventory items – FIFO for this and LIFO for that. How do you like that?!
Once again, a company may use one inventory costing method for one inventory item, and a different method for another item. In the end, the various items will be lumped together on one inventory line on the Balance Sheet and reflected as such in COGS. There might be a footnote indicating that inventory was valued using both FIFO and LIFO (and perhaps still another method), but further details may be absent. Talk about confusing!