Chapter 6 Inventories 277COMPARING INVENTORY COSTING METHODS
As we have illustrated, a different cost flow is assumed for each of the three alterna-
tive methods of costing inventories. You should note that if the cost of units had re-
mained stable, all three methods would have yielded the same results. Since prices
do change, however, the three methods will normally yield different amounts for
(1) the cost of the merchandise sold for the period, (2) the gross profit (and net in-
come) for the period, and (3) the ending inventory. Using the preceding examples
for the periodic inventory system and assuming that net sales were $15,000, the par-
tial income statements shown below indicate the effects of each method when prices
are rising.^1
As these partial income statements show, the fifo method yielded the lowest
amount for the cost of merchandise sold and the highest amount for gross profit (and
net income). It also yielded the highest amount for the ending inventory. On the other
hand, the lifo method yielded the highest amount for the cost of merchandise sold,
the lowest amount for gross profit (and net income), and the lowest amount for end-
ing inventory. The average cost method yielded results that were between those of fifo
and lifo.Compare and contrast the
use of the three inventory
costing methods.
6
1 Similar results would also occur when comparing inventory costing methods under a perpetual inven-
tory system.Partial Income Statements
First-In, First-Out Average Cost Last-In, First-Out
Net sales $15,000 $15,000 $15,000
Cost of merchandise sold:
Beginning inventory $ 1,800 $ 1,800 $ 1,800
Purchases 8,600 8,600 8,600
Merchandise available
for sale $10,400 $10,400 $10,400
Less ending inventory 3,400 3,120 2,800
Cost of merchandise sold 7,000 7,280 7,600
Gross profit $ 8,000 $ 7,720 $ 7,400Use of the First-In, First-Out Method
When the fifo method is used during a period of inflation or rising prices, the earlier
unit costs are lower than the more recent unit costs, as shown in the preceding fifo ex-
ample. Much of the benefit of the larger amount of gross profit is lost, however, be-
cause the inventory must be replaced at ever higher prices. In fact, the balance sheet
will report the ending merchandise inventory at an amount that is about the same
as its current replacement cost. When prices are increasing, the larger gross
profits that result from the fifo method are often called inventory profitsorillusory prof-
its. You should note that in a period of deflation or declining prices, the effect is just
the opposite.