Presented below is a comparison of the effect of the FIFO, average cost, and LIFO cost flow assumptions on ending inventory, cost of goods sold, and gross margin for the Cerf Company (we have not included specific identification in this comparison because of its limited use). The highest gross margin and ending inventory and lowest cost of goods sold result when FIFO is used; the lowest gross margin and ending inventory and highest cost of goods sold result when LIFO is used. The average cost falls between these two extremes for all three accounts.
This is because the acquisition price of the inventory consistently rises during the year, from $4.10 to $4.70. We deliberately constructed this example to reflect rising prices because, in today’s economy, rising prices are more common than are falling prices. However, in some sectors of the economy, such as electronics, prices have been falling. In this case, the income statement and balance sheet effects of LIFO and FIFO would be the opposite of the rising-price situation. That is, LIFO would Produce the highest gross margin and the highest ending inventory cost.
Note: The figures are taken from the example illustrated in the article “Applications of different cos flow assumptions“.
Rising Prices And FIFO
In a period of rising prices, FIFO produces the highest gross margin and the highest ending inventory. The high gross margin is produced because the earliest and thus the lowest costs are allocated to cost of goods sold. Thus, cost of goods sold is the lowest of the three inventory costing methods, and gross margin is correspondingly the highest of the three methods.