Lesson 2 of 8 · All lessons in this module
- Inventory cost formulas and inventory systemsVideo lesson
- Rising and falling costs: effects on statements and ratiosVideo lesson
- The LIFO reserve, LIFO-to-FIFO conversion and LIFO liquidationVideo lesson
- Measuring inventory: lower of cost and net realisable valueVideo lesson
- Inventory write-downs: effects on ratios and analysis
- Inventory disclosures, ratios and analyst checks
- Integrated cases: reading the inventory note and restating to one basis
- Integrated cases: a two-year ratio panel and 'what if the cost formula changed'
Lesson 2 of 8 · 14 min
Rising and falling costs: effects on statements and ratios
When unit costs rise, FIFO reports lower cost of sales, higher profit and higher inventory than LIFO or weighted average; when costs fall, every one of those effects reverses.
In short
- Rising costs, stable or growing quantities: FIFO → lowest cost of sales, highest gross profit, highest inventory. LIFO → the opposite. Weighted average sits between.
- Falling costs: FIFO → highest cost of sales and lowest profit and inventory; LIFO → highest profit.
- FIFO inventory ≈ current replacement cost; LIFO cost of sales ≈ current replacement cost.
- Rising costs: LIFO looks less profitable and less liquid but more efficient (higher inventory turnover) than FIFO. The extra efficiency is an accounting illusion.
- The effects spread to taxes, net income, retained earnings, total assets and ratios such as the current ratio, ROA and debt-to-equity.
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