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

Since president of the company is paid year-end bonus according to the amount of net income earned during the year, president will want net income of the company to be higher. If net income is required to be higher, cost of goods sold should be lower for it.

Under FIFO method, goods purchased first are sold first, since prices are rising purchases made earlier will be at lower prices, hence when FIFO method is followed, cost of goods sold will be from earliest purchases which are at lower prices which makes cost of goods lower and net income higher.

Below is the example to prove this.

		Cost of Goods Available for Sale
Date	Activity	Units	Unit Price	Amount
1	Purchase	100	$             10.00	$           1,000
2	Purchase	100	$             11.00	$           1,100
3	Purchase	100	$             12.00	$           1,200
4	Purchase	100	$             13.00	$           1,300
5	Purchase	100	$             14.00	$           1,400
	Total	500		$           6,000

The above are the purchases made, suppose 400 units are sold, under FIFO Cost of Goods Sold will be $4600 i.e. $1000+1100+1200+1300, whereas under weighted average cost flow, Cost of Goods sold will be $4800 i.e. $6000/500 x 400

So FIFO method is chosen when prices at rising, to show net income on higher side

No, choice will change, since prices are falling, FIFO cost of goods sold will be higher, as it is from earliest purchases which is at higher side. In this situation, weighted average method will be chosen

		Cost of Goods Available for Sale
Date	Activity	Units	Unit Price	Amount
1	Purchase	100	$             14.00	$           1,400
2	Purchase	100	$             13.00	$           1,300
3	Purchase	100	$             12.00	$           1,200
4	Purchase	100	$             11.00	$           1,100
5	Purchase	100	$             10.00	$           1,000
	Total	500		$           6,000

FIFO Cost of Goods Sold will be $5000, whereas Weighted Average Cost of Goods sold will be $5000