Question

explain how a company's choice of an inventory method can affect its net income. do circumstances exist in which the effects would be different or in which there would be no effect?

Explain in detail.

Answer 1

The choice of an inventory valuation method affects the calculation for cost of goods, which affects gross profit and net income. Basically there are 3 methods which can affect the net income of a company:

1. FIFO (First in First Out);
2. LIFO (Last in First Out);
3. Weighted Average method.

FIFO - The FIFO valuation method assumes that the first inventory item purchased is the first one used in production or sold. For example, if a small business has 10 items in stock worth $20 each and it purchases 10 additional items for $24 each, the FIFO method would assume that items in the first sales transaction come from the $20 lot. In an inflationary environment, the cost of goods includes the less expensive items while ending inventory includes the more expensive items. This means that the net income and ending inventory amounts are higher under the FIFO method. However, in a deflationary environment, the FIFO method is likely to generate lower net income.

LIFO - The LIFO valuation method assumes that the last inventory items purchased is the first one used in production or sale. As per our previous example, the LIFO method would assume that items in the first sales transaction come from the latter $24 lot. In an inflationary environment, the cost of goods includes the more expensive items while ending inventory includes the less expensive items. This means that the net income and ending balance amounts are lower under the LIFO method. However, when prices are falling, the LIFO method is likely to generate higher net income.

Weighted Average - The weighted-average method divides the total purchase costs by the number of units in inventory to compute the average unit cost. For example, the average unit cost for purchases of 10 units at $100 each and 20 units at $50 each is 10 multiplied by $100 plus 20 multiplied by $50 -- which is $2,000 -- divided by 10 plus 20, or about $67. The weighted-average costs are directly proportional to the purchase costs. Therefore, in a rising price environment, the average unit costs are higher and net income is lower, while the opposite is true in a falling price environment.

Coming to the next part of the question that, do circumstances exist in which the effects would be different or in which there would be no effect? Yes, there can be a circumstance were the seller has to purchase goods at a constant rate were number of units does not affect the price per unit and than the seller has to sell them by any method(LIFO or FIFO) it will not affect the margins as the seller has acquired the goods at a constant or fixed rate.