Correct Option: A. FIFO (First-In, First-Out)
Explanation of Why FIFO Results in Higher Net Income During Rising Prices
- Understanding Inventory Valuation Methods:
- FIFO (First-In, First-Out): This method assumes that the oldest inventory items are sold first. Therefore, the cost of goods sold (COGS) reflects the cost of older, typically cheaper inventory.
- LIFO (Last-In, First-Out): This method assumes that the most recently purchased inventory items are sold first. In times of rising prices, this means that the COGS reflects the cost of newer, more expensive inventory.
- Weighted Average Cost: This method averages the cost of all inventory items available for sale during the period and applies that average to COGS.
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Specific Identification: This method tracks the actual cost of each specific item sold, which can be complex and is typically used for unique or high-value items.
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Impact of Rising Prices:
- In periods of inflation or rising prices, the cost of inventory increases over time.
- Under FIFO, since the older (and cheaper) inventory costs are used to calculate COGS, the COGS will be lower compared to LIFO. This results in a higher gross profit and, consequently, a higher net income.
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Conversely, LIFO will report higher COGS because it uses the more expensive inventory costs, leading to lower gross profit and net income.
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Example Calculation:
- Assume a company has the following inventory purchases:
- 100 units at $10 each (oldest)
- 100 units at $15 each (newer)
- If the company sells 150 units:
- Using FIFO:
- COGS = (100 units x $10) + (50 units x $15) = $1,000 + $750 = $1,750
- Using LIFO:
- COGS = (100 units x $15) + (50 units x $15) = $1,500 + $750 = $2,250
- If the selling price per unit is $20:
- FIFO Net Income: Revenue = 150 units x $20 = $3,000; Net Income = $3,000 - $1,750 = $1,250
- LIFO Net Income: Revenue = $3,000; Net Income = $3,000 - $2,250 = $750
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As shown, FIFO results in a higher net income of $1,250 compared to LIFO's $750.
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Why Other Options Are Weaker:
- B. LIFO: As explained, LIFO results in higher COGS during rising prices, leading to lower net income. This is the opposite of what the question asks.
- C. Weighted Average Cost: This method smooths out price fluctuations by averaging costs. While it may provide a middle ground, it does not typically yield the highest net income compared to FIFO in a rising price environment.
- D. Specific Identification: This method is not commonly used for general inventory and is more applicable to unique items. It does not inherently favor higher or lower net income as it depends on the specific items sold.
Revision Summary:
- FIFO results in the highest net income during rising prices due to lower COGS from older, cheaper inventory.
- LIFO leads to higher COGS and lower net income in inflationary periods.
- Weighted Average Cost averages costs, providing moderate results, while Specific Identification is less relevant for general inventory.
- Understanding the implications of each method is crucial for financial reporting and analysis.