Question

Assume that you are the president of your company and paid a year-end bonus according to the amount of net income earned during the year. When prices are rising, would you choose a FIFO or weighted average cost flow assumption? Explain, using an example to support your answer. Would your choice be the same if prices were falling?

Answer 1

When prices are rising, FIFO method would be preferred for cost flow assumption. The reason being the inventory will be valued at latest purchase price and hence closing stock will be valued at current market price which is higher than earlier purchase price.

Example.

If opening stock is 50 units at $5, on Jan 5th purchase is made of 50 units at $6, Jan 15th purchase is made of 50 units at $7 and sale is made on Jan 30th for 100 units. Inventory under FIFO cost flow method will be 50*$7 =$350 which is valued at last purchase price. Closing inventory will be valued higher leading to higher profits during the period.

If prices are falling LIFO method would be preferred. Reason being the last purchase is at lower price and hence it should be issued to cost of goods sold under LIFO basis. Closing stock will be valued at earlier purchase price which will be higher and lead to higher profits.