In a period of rising prices, which inventory method provides the highest amount of net income

By Chron Contributor Updated November 19, 2020

Your company has three inventory costing methods from which to choose. The choice is important because it influences your cost of goods sold, net income and income tax payable. Whichever method you choose, accounting rules call for you to stick with it; the Internal Revenue Service might not allow you to flip-flop your accounting method just to take advantage of the latest price trend.

Last-in, first-out, or LIFO, uses the most recent costs first. When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income. If you sell one-of-a-kind items like custom jewelry, you might prefer the specific identification method. You record the cost of each item, so the cost of goods sold doesn’t require as much fancy math.

When you use the periodic, or book, inventory system, you value your inventory at specific intervals and lump together the results. For example, suppose you purchase 10 items at $100 each on the first of the month. On the 14th, you sell six items and on the 16th buy another 10 for $120 each. You sell eight items on the 19th and buy another 10 on the 23rd for $130 each. On the last day of the month, you sell nine items. Under periodic inventory LIFO, your cost of goods sold is the sum of 10 items times $130, 10 items times $120 and three items times $100. This adds up to $2,800, and you value your remaining inventory at $700.

In the perpetual inventory system, you figure the cost at the time of each sale instead of at specific intervals. Your cost of goods sold on the 14th is six items times $100, or $600. The sale on the 19th costs $120 times eight units, or $960. The last sale costs $130 times nine items, or $1,170. Notice that each sale uses the latest item cost, which simplifies the math. The total cost is $2,730, or $70 less than the cost under the periodic inventory method. Your remaining inventory tallies in at $770. Your taxable income is $70 less using the periodic inventory system. If you are in the 25 percent bracket, this translates into a tax savings of $17.50.

Since prices always seem to increase over time, LIFO is a good bet for consistently maximizing your cost of goods sold. The example deals with a retail situation but also applies to product manufacturers. However, if you manufacture products using raw materials that fluctuate in price, such as petroleum, you may not always benefit from the LIFO method. The IRS lets you initially choose your inventory accounting method but wants you to use it consistently year to year. If you choose LIFO, you must file IRS Form 970 in the first year you use this method. If you want to change methods, you might need to ask for IRS approval by filing Form 3115.

The accounting for the costs of inventory depends on the cost flow method you chose. The four ones in common use are last in, first out (LIFO), first in, first out (FIFO), specific identification and weighted average cost. Each method can give a different value to ending inventory, cost of goods sold and net income. A higher COGS creates a lower, though not necessarily realistic, net income and reduces taxes.

Reality

1. A company’s net income is “realistic” if it arises from a matching of COGS to revenues. Matching of costs and revenues is a central feature of accrual accounting under generally accepted accounting principles. Since net income appears on the income statement, the realistic method is the one in which costs most closely tie to revenues for the period. You might get a different answer if you ask which method gives you the most realistic ending inventory -- it should give an answer that values ending inventory at current values and thus provides the most realistic view of the company’s balance sheet assets.

LIFO

1. Under LIFO, you make believe you sell your most recently purchased inventory items first. The real inventory flow might bear no resemblance to the cost flow -- you might actually sell your oldest items first and still adopt LIFO for accounting purposes. 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.

FIFO

1. GAAP also allows the FIFO method, which assumes you sell your inventory items as if they were stored in a queue. You sell the oldest inventory items ahead of the most recent ones. This doesn’t fit well with GAAP requirements for realistic net income since you match obsolete prices with the most current revenues. Conversely, FIFO gives you the timeliest value for ending inventory, since the unsold items reflect the most current costs. In periods of rising prices, FIFO leads to the highest income and taxes.

Other Methods

1. Specific identification of the cost and revenue for each inventory item gives the most realistic values for COGS and ending inventory. However, this might not be the case for net income if you purchase identical items at different prices. Your choice of which one you sell might be random and thus not satisfy the matching principle. For example, if you receive three shipments of identical diamond earring sets at different prices, you might be able to identify each specific earring set. Nevertheless, if you sell the oldest one first, your haven’t matched current costs to revenues. The weighted average cost method gives realistic net income only if you purchase all available-for-sale units of the same merchandise item at identical prices.

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