Comparing Inventory Costing Methods Obj. 5 A different cost flow is assumed for the FIFO, LIFO, and weighted average inventory cost flow methods. As a result, the three methods normally yield different amounts for the following: Cost of merchandise sold Gross profit Net income Ending merchandise inventory See Appendix B for more information. Using the perpetual inventory system illustration with sales of $39,000 (1,300 units $30), the following differences are apparent:Sales Cost of merchandise sold Gross profit Merchandise Inventory, Jan. 31 Partial Income Statements First-In, First-Out $39.000 26.720 $12.280 $18,460 Weighted Average Cost $39,000 26.900 $12,100 $18,280 Last-In, First-Out $39,000 27.200 $11,800 $17,980Details Partial income statements comparing sales, cost of merchandise sold, gross profit, and ending merchandise inventory for the three inventory costing methods are shown. The table has three column headingsFirst-In, First-Out; Weighted Average Cost; and Last-In, First-Out. In the First-In, First-Out column, Sales are $39,000 and Cost of merchandise sold is 26,720. A single rule appears below the number 26,720. Gross profit is $12,280. A double rule appears below $12,280. Merchandise Inventory, Jan. 31 is $18,460. A double rule appears below $18,460. In the Weighted Average Cost column, Sales are $39,000 and Cost of merchandise sold is 26,900. A single rule appears below the number 26,900. Gross profit is $12,100. A double rule appears below $12,100. Merchandise Inventory, Jan. 31 is $18,280. A double rule appears below $18,280. In the Last-In, First-Out column, Sales are $39,000 and Cost of merchandise sold is 27,200. A single rule appears below the number 27,200. Gross profit is $11,800. A double rule appears below $11,800. Merchandise Inventory, Jan. 31 is $17,980. A double rule appears below $17,980. The Gross profit and Merchandise Inventory, Jan.31 rows are highlighted in yellow. The preceding differences show the effect of increasing costs (prices). If costs (prices) remain the same, all three methods would yield the same results. However, costs (prices) normally do change. The effects of changing costs (prices) on the FIFO and LIFO methods are summarized in Exhibit 8. The weighted average cost method will always yield results between those of FIFO and LIFO.

Details A table illustrating the effects of changing costs (prices) on the FIFO and LIFO methods is shown. The table contains two main columns: Increasing Costs (Prices) and Decreasing Costs (Prices). A green upward-pointing arrow appears to the left of the Increasing Costs (Prices) heading, and a red downward-point arrow appears to the left of the Decreasing Costs (Prices) heading. Both columns are subdivided into two columns: Highest Amount and Lowest Amount. For Cost of merchandise sold, the methods are as follows: Increasing Costs (Prices) Highest Amount: LIFO; Increasing Costs (Prices) Lowest Amount: FIFO; Decreasing Costs (Prices) Highest Amount: FIFO; Decreasing Costs (Prices) Lowest Amount: LIFO. For Gross profit, the methods are as follows: Increasing Costs (Prices) Highest Amount: FIFO; Increasing Cost (Prices) Lowest Amount: LIFO; Decreasing Costs (Prices) Highest Amount: LIFO; Decreasing Costs (Prices) Lowest Amount: FIFO. For Net income, the methods are as follows: Increasing Costs (Prices) Highest Amount: FIFO; Increasing Costs (Prices) Lowest Amount: LIFO; Decreasing Costs (Prices) Highest Amount: LIFO; Decreasing Costs (Prices) Lowest Amount: FIFO. For Ending merchandise inventory, the methods are as follows: Increasing Costs (Prices) Highest Amount: FIFO; Increasing Costs (Prices) Lowest Amount: LIFO; Decreasing Costs (Prices) Highest Amount: LIFO; Decreasing Costs (Prices) Lowest Amount: FIFO. All LIFO entries are shown in green, and all FIFO entries are shown in blue. FIFO reports higher gross profit and net income than the LIFO method when costs (prices) are increasing, as shown in Exhibit 8. However, in periods of rapidly rising costs, the inventory that is sold must be replaced at increasingly higher costs. In such cases, the larger FIFO gross profit and net income are sometimes called inventory profits or illusory profits. During a period of increasing costs, LIFO matches more recent costs against sales on the income statement. Thus, it can be argued that the LIFO method more nearly matches current costs with current revenues. LIFO also offers an income tax savings during periods of increasing costs. This is because LIFO reports the lowest amount of gross profit and, thus, taxable net income. However, under LIFO, the ending inventory on the balance sheet may be quite different from its current replacement cost. In such cases, the financial statements normally include a note that estimates what the inventory would have been if FIFO had been used. The weighted average cost method is, in a sense, a compromise between FIFO and LIFO. The effect of cost (price) trends is averaged in determining the cost of merchandise sold and the ending inventory. Integrity, Objectivity, and Ethics in Business Wheres the Bonus? Managers are often given bonuses based on reported earnings numbers. This can create a conflict. LIFO can improve the value of the company through lower taxes. However, in periods of rising costs (prices), LIFO also produces a lower earnings number and, therefore, lower management bonuses. Ethically, managers should select accounting procedures that will maximize the value of the firm rather than their own compensation. Compensation specialists can help avoid this ethical dilemma by adjusting the bonus plan for the accounting procedure differences.

Reporting Merchandise Inventory in the Financial Statements Obj. 6 Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases: The cost of replacing items in inventory is below the recorded cost. The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes.

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