182 Learning Module 6 Analysis of Inventories
of sales on the income statement and a higher amount to ending inventory on the
balance sheet. Accordingly, because cost of sales will be lower under FIFO, a company’s
gross profit, operating profit, and income before taxes will be higher.
The carrying amount of inventories under FIFO will more closely reflect current
replacement values because inventories are assumed to consist of the most recently
purchased items. The cost of sales under LIFO will more closely reflect current replace-
ment value. LIFO ending inventory amounts typically are not reflective of current
replacement value because the ending inventory is assumed to be the oldest inventory
and costs are allocated accordingly. Example 3 illustrates the different results obtained
by using either the FIFO or LIFO methods to account for inventory.
EXAMPLE 3
Impact of Inflation Using LIFO Compared to FIFO
Company L and Company F are identical in all respects except that Company L
uses the LIFO method and Company F uses the FIFO method. Each company
has been in business for five years and maintains a base inventory of 2,000
units each year. Each year, except the first year, the number of units purchased
equaled the number of units sold. Over the five year period, unit sales increased
10 percent each year and the unit purchase and selling prices increased at the
beginning of each year to reflect inflation of 4 percent per year. In the first year,
20,000 units were sold at a price of USD15.00 per unit and the unit purchase
price was USD8.00.
1. What was the end-of-year inventory, sales, cost of sales, and gross profit for
each company for each of the five years?
Solution:
Company L using LIFO
(in USD) Year 1 Year 2 Year 3 Year 4 Year 5
Ending inventorya 16,000 16,000 16,000 16,000 16,000
Salesb 300,000 343,200 392,621 449,158 513,837
Cost of salesc 160,000 183,040 209,398 239,551 274,046
Gross profit 140,000 160,160 183,223 209,607 239,791
a Inventory is unchanged at USD16,000 each year (2,000 units × USD8). 2,000 of the units
acquired in the first year are assumed to remain in inventory.
b Sales Year X = (20,000 × USD15)(1.10)X–1(1.04)X–1. The quantity sold increases by 10 percent
each year and the selling price increases by 4 percent each year.
c Cost of sales Year X = (20,000 × USD8)(1.10)X–1(1.04)X–1. In Year 1, 20,000 units are sold with
a cost of USD8. In subsequent years, the number of units purchased equals the number of units
sold and the units sold are assumed to be those purchased in the year. The quantity purchased
increases by 10 percent each year and the purchase price increases by 4 percent each year.
If the company sold more units than it purchased in a year, inventory would
decrease. This is referred to as LIFO liquidation. The cost of sales of the
units sold in excess of those purchased would reflect the inventory carrying
amount. In this example, each unit sold in excess of those purchased would
have a cost of sales of USD8 and a higher gross profit.
The Effects of Inflation and Deflation on Inventories, Costs of Sales, and Gross Margin 183
Company F using FIFO
(in US dollars) Year 1 Year 2 Year 3 Year 4 Year 5
Ending inventorya 16,000 16,640 17,306 17,998 18,718
Salesb 300,000 343,200 392,621 449,158 513,837
Cost of salesc 160,000 182,400 208,732 238,859 273,326
Gross profit 140,000 160,800 183,889 210,299 240,511
a Ending Inventory Year X = 2,000 units × Cost in Year X = 2,000 units [USD8 × (1.04)X–1]; 2,000
units of the units acquired in Year X are assumed to remain in inventory.
b Sales Year X = (20,000 x USD15)(1.10)X-1(1.04)X-1.
c Cost of sales Year 1 = USD160,000 (= 20,000 units × USD8). There was no beginning inventory.
Cost of sales Year X (where X ≠ 1)
= Beginning inventory plus purchases less ending inventory
= (Inventory at Year X–1) + [(20,000 × USD8)(1.10)X–1(1.04)X–1]
− (Inventory at Year X)
= 2,000(USD8)(1.04)X–2 + [(20,000 × USD8)(1.10)X–1(1.04)X–1] – [2,000
(USD8)(1.04)X–1].
For example, cost of sales Year 2
= 2,000(USD8) + [(20,000 x USD8)(1.10)(1.04)] – [2,000(USD8)(1.04)]
= USD16,000 + USD183,040 – USD16,640 = USD182,400.
2. Compare the inventory turnover ratios (based on ending inventory carrying
amounts) and gross profit margins over the five-year period and between
companies.
Solution:
Company L Company F
Year 1 2 3 4 5 1 2 3 4 5
Inventory 10.0 11.4 13.1 15.0 17.1 10.0 11.0 12.1 13.3 14.6
turnover
Gross profit 46.7 46.7 46.7 46.7 46.7 46.7 46.9 46.8 46.8 46.8
margin (%)
Inventory turnover ratio = Cost of sales ÷ Ending inventory.
The inventory turnover ratio increased each year for both companies
because the units sold increased, whereas the units in ending inventory
remained unchanged. The increase in the inventory turnover ratio is higher
for Company L because Company L’s cost of sales is increasing for infla-
tion, but the inventory carrying amount is unaffected by inflation. It might
appear that a company using the LIFO method manages its inventory more
effectively, but this is deceptive. Both companies have identical quantities
and prices of purchases and sales and only differ in the inventory valuation
method used.
Gross profit margin = Gross profit ÷ Sales.
The gross profit margin is stable under LIFO because both sales and cost of
sales increase at the same rate of inflation. The gross profit margin is slightly
