Question

If you were attempting to maximize your net income, which inventory cost flow assumption would you choose? Why? What conditions must exist for this method to produce the highest net income? When perpetual inventory records are kept, the results under the FIFO and LIFO methods are the same as they would be in a periodic inventory system.” Do you agree? Explain.

Answer 1

Inventory cost flow assumption often refers to methods available for moving costs from the inventory to consumption and maintianence of the cost records. Following are the methods which is generally used-

1 Last in first out (LIFO) method;

2 First in first out (FIFO) methid

3. Weighted average method.

4. Simple average method.

Generation of net income depends on the pricing cycle of the economy and when inventory pricing are rising at regular interval then FIFO method would generate the higher net income. e.g. lets say on 01 January- price is USD 100 and on 31 Dec- price is USD 120, then USD 120 unit will remain in the inventory and USD 100 unit will be charged to statement for profit and loss. Hence, net income would be higher by USD 20.

At the same time, if prices are not moving much during the period, then all the method will result similar result.

During the period, prices are falling, LIFO method will result in highest income.

Perpetual system v/s Periodic system-

Perpetual system of costing is way of maintaining cost records wherein all the records are maintained online and information is upto date every point of time. Whereas under periodic system, business needs to be stopped for counting of inventory and identifying the unit consumed during the period.

Inventory valuation either based on LIFO or FIFO method does not change due to costing system vi.z periodic v/s perpetual as method of costing remains the same.

Perpetual method is superior due to-

1. Easy and regular access to information.

2. More accurate and reliable.

3. More accurate and update business decision making.

However following are demerits-

1. Costly- needs to invest in hardware and software.

2. Need more manpower.

3. Cumbersome and extra work load on management for monitoring.

In the current environment, inspite of demerits, perpetual system is more appropriate because time is money and decision making has changed completely.