Question

1)  From a user perspective, how does gross profit, operating income, and net income differ? Is one more important than another?

2) In determining the cost of merchandise sold and the cost of ending inventory, how does the FIFO method differ from the LIFO method?

3) How is the accounting of inventory influenced by the periodic inventory system versus the perpetual inventory system?

Answer 1

1) The terms "profit" and "income" are often used interchangeably in day-to-day life. In corporate finance, however, these terms can have very different and specific meanings, depending on the context in which they are used.

While income does mean positive flow of cash into a business, net income is something much more complex. Profit is generally understood to refer to the cash that is left over after accounting for expenses. Though both gross profit and operating profit fit this definition in the simplest sense, the kinds of income and expenses that are accounted for differ in important ways.

2) FIFO and LIFO are methods used in the cost of goods sold calculation. FIFO (“First-In, First-Out”) assumes that the oldest products in a company’s inventory have been sold first and goes by those production costs. The LIFO (“Last-In, First-Out”) method assumes that the most recent products in a company’s inventory have been sold first and uses those costs instead.

3) Periodic and perpetual inventory systems are two contrasting accounting methods that businesses use to track the number of products they have available. Overall, the perpetual inventory system offers many benefits over the periodic system and is now used by all major retailers. However, a small business owner must still take into account whether the benefits of installing a perpetual inventory system will outweigh the additional expense.