FIFO vs LIFO — how exactly do they affect COGS, ending inventory, and net income during rising prices?

This is a classic CFA Level I FRA question and it shows up on nearly every exam. The key is understanding how the **cost flow assumption** determines which costs go to COGS (income statement) versus ending inventory (balance sheet). **The Rule of Thumb (Rising Prices):** | Metric | FIFO | LIFO | |--------|------|------| | COGS | **Lower** (older, cheaper costs) | **Higher** (newer, expensive costs) | | Ending Inventory | **Higher** (newer, expensive costs remain) | **Lower** (older, cheaper costs remain) | | Gross Profit | **Higher** | **Lower** | | Net Income | **Higher** | **Lower** | | Taxes | **Higher** | **Lower** | **Worked Example:** Hargrove Supply Co. sells industrial fasteners. In Q1, their purchases were: | Date | Units | Unit Cost | Total Cost | |------|-------|-----------|------------| | Jan 5 | 200 | $10 | $2,000 | | Feb 12 | 300 | $12 | $3,600 | | Mar 20 | 250 | $15 | $3,750 | | **Total** | **750** | | **$9,350** | During Q1, Hargrove sold **500 units** at $22 each. Revenue = $11,000. **Under FIFO** (sell oldest first): - COGS = (200 x $10) + (300 x $12) = $2,000 + $3,600 = **$5,600** - Ending inventory = 250 x $15 = **$3,750** - Gross profit = $11,000 - $5,600 = **$5,400** **Under LIFO** (sell newest first): - COGS = (250 x $15) + (250 x $12) = $3,750 + $3,000 = **$6,750** - Ending inventory = (200 x $10) + (50 x $12) = $2,000 + $600 = **$2,600** - Gross profit = $11,000 - $6,750 = **$4,250** **The Impact:** - FIFO shows **$1,150 more gross profit** ($5,400 vs $4,250) - FIFO shows **$1,150 more in ending inventory** ($3,750 vs $2,600) - At a 25% tax rate, FIFO results in $287.50 more in taxes **Why It Matters for Analysis:** When comparing two companies using different methods, you need to adjust. The **LIFO reserve** (disclosed in footnotes) lets you convert LIFO to FIFO: - FIFO inventory = LIFO inventory + LIFO reserve - FIFO COGS = LIFO COGS - Change in LIFO reserve **Important note:** IFRS does **not** allow LIFO. Only US GAAP permits it. The exam loves testing this distinction. For a deeper dive into inventory methods and their analytical adjustments, check out our CFA Level I Financial Reporting course on AcadiFi.